If the same alien said: “Take me to the bond market”, where would you go? The vaults of the Bank of England, where hopefully there are a couple hundred billion pounds worth of gilt edged certificates lying around as evidence of QE? Or the dealing room of an investment bank where you could show them a Bloomberg screen and swear that the prices on display were real?
Reality check
Rather like Blanche DuBois from A Streetcar Named Desire, the bond market has “…always depended on the kindness of strangers” to ensure that the prices on the screen could actually be traded at. One of the problems for markets today is that the prices at which both government and corporate bonds are indeed trading is suggesting a much bleaker outlook than the price at which equities are trading.
To give one example, investment grade credit spreads in the US are at levels last seen in the summer of 2009 when the US equity market was around 15% lower than its current level.
One of the issues for the corporate bond market is that it has a heavy weighting towards financials. The Barclays Aggregate US Corporate Bond index is 34% composed of financial issuers. The European version of that index is 50% financials. Clearly, one of the major problems in the world today is that no one really knows which individual financial institutions would be vulnerable if there is, for example, a messy Greek default. Hence the market turns its speculative attention on everything from Belgian retail banks to American investment banks. This has meant that financial credit is making the overall corporate bond market weaker.
The financial sector is also the weakest part of the equity market. But with financials representing only 14% of the US equity market and 18% of the European, there have been some offsets to the weakness in the sector. Most notably that has been, until the last few weeks, companies with exposure to emerging markets. These have included consumer and capital goods companies, as well as those in the materials sector.
Govvie arbitrage
But let’s not fool ourselves into thinking that the extreme weakness in credit is somehow distorted by that heavy financials weighting. For the government bond market is giving a similarly alarming message.
The yield on government bonds is hovering around record lows on both sides of the Atlantic. As we have to keep reminding ourselves, the yield on government bonds and the nominal growth rate of the economy need, over time, to be similar. If they are not then an arbitrage opens up between the return available from investing in the economy and from lending money to the government.
There has been a lot of discussion about how QE and other central bank actions have distorted the bond market and pushed yields down. We suspect this is exaggerated though, not only because the Bank of England estimate that QE has at most reduced bond yields by 0.5% to 1%, with most of it happening in anticipation of QE. Let’s see what the impact of the eminently justified resumption of QE here has.
We are also sceptical because the relationship between bond yields and nominal growth is actually holding up rather well. Through the second quarter of 2011, the rolling five-year average of US nominal GDP growth was 2.6%. Through the third quarter, the rolling five-year average of the yield on the nominal five-year note was 2.7%. Where is the distortion in that?
Risk premium
This is deeply alarming though. Most forecasters continue, as does Bernanke, to suggest that the long-run potential growth rate of the world’s largest economy is not imperilled by the ongoing repercussions of the financial crisis and Great Recession. But the government bond market definitely has doubts about that sustainable growth rate being anything like its historic 5%.
Doubt about what the prospective growth rate is for the economy and by extension the corporate sector remains a major headwind for markets. Without confidence in the critical variable for calculating relative value – the prospective growth rate of corporate earnings or dividends – risk premiums are likely to stay elevated. Indeed, my UK equity risk premium uses a 5% nominal growth rate assumption which makes equities look as cheap relative to bonds as they were in April 2009, just after the equity market bottomed. Use a 3% growth rate and equities are about the same relative valuation as in March 2008, a rather less attractive parallel to draw.
It is also alarming for a world that requires growth to assist in the deleveraging process. Government deficits, for example, cannot be reduced by cutting spending alone. Revenues must rise and the only way to get revenues up is to get national income growing at a reasonable rate to keep the tax base growing.
There had been hope that emerging markets could offset some of the developed world weakness but faith in that is disappearing. Emerging market (EM) indices have been underperforming the developed world since April and developed world stocks with large EM business have also been weak. Frankly, we are not surprised by this as the EM complex is still dependent on the developed world (particularly those parts running current account deficits) for its own growth.
Indeed one of the great illusions about EM is that they will ‘emerge’. Since MSCI began calculating its EM series in 1988, only three countries have moved from the EM index to the developed one, namely Israel, Greece and Portugal. Israel is a bit of a special case being a country with a high GDP per capita and where a number of its larger companies were traded actively on the US NASDAQ market. Greece and Portugal however did ‘emerge’ as they joined the euro area and became, apparently, success stories. Wouldn’t it be ironic if one of the end results of the European crisis was for one or both of these two to be sent back down to the EM index?
A Streetcar Named Desire is a harrowing depiction of reality destroying illusion. At an earlier point in the play, Blanche says “I don’t want realism. I want magic!” She must have been an investor. Ben, Mervyn and Jean-Claude didn’t really deliver much magic. Can Mario Draghi be the Magic Man? It’s getting to the point where we have to hope so.
