“Neutrality is at times a graver sin than belligerence.” – Louis D. Brandeis
In May, an escalation in the US-China trade dispute and President Trump’s reversal on the trade pact with Mexico, albeit short-lived, damaged business confidence and sufficiently raised uncertainty to cause corporations to re-think their investment plans.
No surprise then that business investment in the US fell by four-fifths of a percentage point, on a quarter-over-quarter basis, during the second quarter and was a major drag on US GDP growth.
President Trump, having raised hopes of an amicable solution to the trade dispute following the G20 meeting in Osaka, once again threw a spanner in the works yesterday. He tweeted that the US will be imposing, starting 1 September, a 10 per cent tariff on the remaining US dollars 300 billion of Chinese imports that hitherto had not been subject to tariffs.
President Trump’s tweets sent Twittersphere into a frenzy and caused stocks to sell off, oil to crater and gold to, well, behave like a safe-haven. And probably delayed corporate investment plans further.
Given the context, may be everyone should be long bonds and it makes sense that:
- Over US dollars 13 trillion of global bonds trading with negative yields;
- Bonds of sub-investment grade issuers in Europe trading with negative yields;
- The German and Swiss yield curves are negative out to more than 20- and 30-years, respectively; and that
- Austria sold a century bond with a yield of just 1.2 per cent.
Or it might be that global bonds trading at record low yields is a signal that either a global recession is underway, which the data will confirm sooner rather than later, or that the world will enter a recession sometime between now and late 2020. An imminent global recession appears to be the consensus view.
In our humble opinion, global bonds trading at record low yields are just as much a signal that a recession is imminent and that inflation is dead as technology stocks trading at market capitalisations of double- and triple-digital multiples of their hypothetical five-year revenues at the height of the tech bubble were of the internet ushering in a new business paradigm.
Sometimes the price is just wrong. Often because of a technicality.
A Digression
Up until 18 March 2005 the S&P 500 Index was a market capitalisation weighted index. That is, the weight of a stock in the index was equal to its market capitalisation divided by the sum of the market capitalisation of all stocks in the index. After 18 March 2005, the S&P 500 Index became a float adjusted capitalisation weighted index. That is, a stock’s weight in the index is equal to its free float market capitalisation – the stock price multiplied by the number of its shares freely available to trade, i.e., all shares excluding those held by insiders, locked-in as part of incentive programmes, held by the government or the promoters – divided by the sum of the free float market capitalisation of all stocks in the index.
The S&P 500 Index weighting calculation being agnostic to the free float and being based purely on a market capitalisation had an unintended consequence. That unintended consequence was the tech bubble.
All else being equal, a stock with fewer freely available shares to trade is less liquid, or illiquid, relative to a stock with more freely available shares to trade. Illiquid stocks tend to have more exaggerated price moves, up or down, than a liquid stock for the same value of buy or sell orders.
During the tech bubble, the market direction was just one way – up. So the upward price moves in illiquid stocks, in general, were greater than those of liquid stocks. And with each passing day, as a result, illiquid stocks started comprising a greater and greater portion of the S&P 500 Index. As their weight in the index grew, the demand for these illiquid stocks grew from (i) passive strategies that allocate based on index weightings and (ii) active managers reducing their tracking error and benchmark risk. The growth in demand for these illiquid stocks was not met with a commensurate increase in the quantity of stock freely available to trade. Rather, the opposite occurred. Those that held the illiquid stocks became averse to trading them. Setting off a vicious spiral that required bubble-like prices for the market to clear. Of course, when the market was ready to clear, nobody wanted the illiquid stocks anymore.
The Bond Technicality
Rather than go through an exhaustive list of technicalities that force bond buying, the below are examples of rules and regulations that have created price insensitive buyers of bonds:
- OECD countries, such as Japan, France, Belgium, Portugal and Denmark, impose a minimum allocation to public sector bonds on their respective pensions plans. The minimum allocations range from 15 to 50 per cent of pension assets.
- Basel III, a set of banking regulations developed by the Bank for International Settlements, increased the ‘Tier 1’ capital ratio – roughly the amount of ‘equity’ banks need to hold as a percentage of risk-weighted assets – and put a zero risk-weight on government bonds. To comply with the more stringent requirements banks have a choice to maintain risk-weight by increasing capital or reduce risk-weight by investing more in government bonds. Most banks chose the latter.
- Quantitative easing. Just as an example, the European Central Bank bought over euros 1.9 trillion of government bonds, roughly 90 per cent of the bonds issued by European governments, over the 45-month period the quantitative easing programme was running.
The global bond prices are not right. It is a technicality. That does not mean you bonds should be shorted, either.
What Does Trump Want?
President Trump is nothing if not belligerent. He will try to get what he wants by any means necessary. But what is it that he wants other than being re-elected for a second term?
Lower Interest Rates, More Spending
The last four US presidents not to be re-elected all oversaw struggling domestic economies going into their re-election campaign. President Trump is undoubtedly aware of this and does not want a tight monetary policy or higher, than needed, interest rates to derail his campaign.
Lower interest rates, moreover, may make it easier for the Trump Administration to continue playing hardball with China. After all, the US economy is far less reliant on trade than most and it is the health of the consumer that tends to determine to fate of the US economy. Lower rates are simply put better for the US consumer.
In this instance investors should be long short-term interest rates. Equity investors should be long high quality consumer packaged companies with a decent yield such as Campbell Soup $CPB.
A Weaker Dollar
A weaker US dollar is generally stimulative for the global economy but also reduces China’s ability to meaningfully weaken its currency to offset any tariffs. Getting a weaker US dollar, at a time when most central banks are cutting rates and easing monetary policy, is not easy. The Fed, of course, is the one central bank that has the capacity to manufacture a weaker US dollar.
In this instance, investors should be long gold and other precious metals.
In neither instance do we think is buying long-term bonds the answer because a world with a weaker US dollar and / or lower interest rates is unlikely to enter a recession.
More importantly, businesses will eventually have to invest and they are most likely to invest in the US – the trade uncertainty is not going to go away anytime soon whether President Trump gets re-elected or not. The US has tight production capacities and low unemployment. Save a new immigration drive, a meaningful increase in business investment in the US or a large government led fiscal spending programme is likely to kindle inflationary forces and precipitate a sell-off in long-term bonds.
This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.