The past few years have been a reminder of how far the relationship between fundamentals and valuation can become stretched when financial markets decide they wish to inflate a bubble. There are many popularly cited examples such as technology a decade ago, the pre 2008 inflated expectations for the banking sector or the periodic surges in enthusiasm for China and commodities. These are all typical examples where euphoria has taken over from sober judgment.
The danger of pessimism-induced bubbles
However, the bubble which perturbs me is more insidious, because it is fuelled by pessimism. There is no gushing over-optimism to give warning that it could be right to jump off the bandwagon. Over-valuation, rather than deterring demand, helps to feed it because of the risk-management rules determining investment policy, for example, at many pension funds.
The bubble I refer to is in government bonds, at least those where investors are giving countries the benefit of the doubt over fiscal policy. In the UK, the US and Europe, central banks have (more or less official) inflation targets of 2%, while in Japan the target is 1%. In Germany, the UK and the US, ten-year bond yields are well below 2%, just as they are below 1% in Japan.
To underline this, index-linked bonds (where repayment values are increased in line with inflation) trade on such a premium that the projected returns for those buying and holding them to maturity are negative in real terms.
What could explain a willingness to lend money to governments at rates which (even before tax) are less than likely inflation rates, entrenching a virtually assured loss in real terms?
Possible explanations include:
- Inflation may be lower than current bond yields, so returns may be better than they appear;
- Investors are willing to accept returns below inflation in exchange for the certainty of being repaid;
- A fear of doing worse either holding cash (given low deposit rates and exposure to banking risk) or investing in assets such as property or equities, where returns have been volatile;
- Interest rates may stay low for many years, meaning bonds are rationally priced even though yields are below inflation;
Some investors are investing for risk management reasons rather than investment return.
These all have a germ of truth in them. However, the near certainty of a real loss from buying ‘safe’ government bonds yielding less than 2% represents an increasingly high insurance premium to avoid capital volatility in other assets. Cynics may also think that central banks setting interest rates are not as independent as they appear of governments trying to sell bonds on low yields.
As with all bubbles, there is never a shortage of justifications for higher prices, until the bubble bursts, at which point substantial losses are incurred.
Short-term loss guaranteed unless…
Gilt investors lost the majority of their money in real terms in the 30 years after 1945, from a starting point of low yields and (understandably) subdued equity markets. Equity investors made substantial gains, since the moderate starting valuation allowed the fruits of economic growth to flow through to share values.
It is hard to predict when the current period of debt adjustment in developed economies will end or how far the process of containing debt can be rendered consistent with economic growth, thus avoiding a rerun of the 1930s. Since 2009, inflation has been higher than expected and company profits better than expected. Although economic growth has been slow, neither the facts on the ground nor the policies adopted by most governments support the worst fears of a rerun on the 1930s.
Given the distortion of a substantial part of the savings market by the policy of near-zero interest rates and the Gadarene rush into government bonds, people need to make their own minds up (or take advice) on where value exists and on their own financial and emotional ability to accept capital risk.
The safe refuges of the past 30 years (bonds and cash) no longer look safe, with yields below inflation. A long period of positive real interest rates has given way to a period of officially-inspired negative real rates (part of the necessary healing process for economies with too much debt).
Those who fail to adapt their investment approach in response are unwittingly accepting a decline in their purchasing power. This may be one of those times when preserving the value of savings means accepting a greater risk of short-term loss.