“You better cut the pizza in four pieces because I'm not hungry enough to eat six.” - Yogi Berra
Before moving to San Francisco in the spring of 1979, we lived in the Bronx. From what I can remember, I was a typical five-year-old boy who enjoyed playing in the snow, getting dressed up as Batman, and dreamed of hitting cleanup for the New York Yankees. At that time, the Yankees were the premier team in baseball, as they had won the World Series back-to-back in 1977 and 1978. Reggie Jackson (aka Mr. October for his epic post-season performance) was my favorite player followed by Bucky Dent. I looked up to both sports stars and fantasized about being as good as them one day.
Fast-forward to the present and it is obvious my life took a detour many years ago. Today, I am less interested in baseball, despise cold weather, and feel silly dressing up in costumes - even if it is Halloween and I get to be Batman. However, I still have role models and for much of my professional career they have been investors such as Bill Gross, Ray Dalio, and Stanley Druckenmiller. When they speak, I listen.
Since the election of Mr. Trump, they have all to varying degrees expressed their belief that the beginning stages of the highly anticipated bear market in bonds is among us. To their point, bonds have been hit hard since November 8th with intermediate and long maturity paper taking the brunt of the move to higher yields, as markets appear to be betting on a combination of higher future growth and inflation. Conversely, major US stock indexes and the dollar have rallied amid expectations of a large fiscal boost coming in the form of future tax cuts, infrastructure spending, and deregulation.
As a mere mortal among investing idols, the enticing play is to go along with the viewpoint of my market seers, however their position now seems to have manifested into consensus thinking. I judge this, by not only referring to current market pricing, but also from the uniform views presented during a recent luncheon I attended given by three separate asset managers. Collectively, the presenters believe bond prices will continue lower (yields higher), while developed market stocks and the dollar will press on. The only difference I could discern among the lot was the magnitude of future price and yield changes. This is just the kind of group-think that worries me most as an investor and money manager, yet also gives me confidence that there could be opportunities ahead.
After the recent large selloff in bonds, it is tempting to conclude the 35-year bull market has come to an end. However, I see nothing in the chart below that confirms this view. The long-term trend in the 30-year bond remains one of lower yield lows and lower yield highs (Figure 1). The trend still appears in place and concluding otherwise is probably more of a forecast rather than a statement of fact. In addition, large price corrections are common, not out of the ordinary, and are to be expected when viewing trends over long time frames (Figure 2).
From a fundamental perspective, there are also reasons to be wary of sounding the bond bear alarm. We in the developed world (US, EU, UK, and JP) are all to some degree in the same demographic boat. In my opinion, it is not a coincidence we have observed similarities in our interest rate markets or growth and inflation trajectories. Japan has been an instructive example in this respect. Yields on Japanese government debt have trended lower over the past 25 years, while fiscal spending has been high, characterized by large deficits and spending on infrastructure projects. Per data provided by the website tradingeconomics.com , Japan’s government debt to GDP ratio is a whopping 229%, yet their 10-year yield currently stands at just 0.056% (data provided by The Wall Street Journal). Trend growth rates in Japan have not recovered and inflation remains persistently low despite everything policy makers have done over the past couple of decades. With a debt to GDP ratio of 104% (data provided by tradingeconomics.com) it would appear the U.S. comparatively has a lot of room to spend more, however there is little proof this will lead to higher sustainable long-term trend growth.
What does this mean for stocks? In the past, I argued that low long-term interest rates were a factor leading to historically high price to earnings ratios in the U.S. market. Since I do believe bond yields are still in a downtrend it makes sense that valuations could remain high which would support stock prices over a long time horizon. Given the recent rally however, I am tempted to be more cautious on a short-term basis. On the dollar, I have become less convinced of a continuing strengthening scenario due to Mr. Trump’s view on U.S. competitiveness and his desire to increase trade through exports.
Going into the U.S. election many market commentators saw Hillary Clinton as the “consensus” candidate and Donald Trump as the “wild card.” That characterization made sense to me at the time and I still believe it holds true now that Mr. Trump is our President elect. From an investing standpoint, this signifies to me that the potential future path of government policy, the economy, asset prices, etc. have likely widened.
Which in turn means the variance between good outcomes and bad outcomes has also probably increased. As an investor presented with a widening probability distribution of future unknowns, it could make sense to discount higher risk premiums into asset prices relative to what is currently being priced in. As far as I can tell, the market appears very one sided and is betting heavily on the wild card.
Sincerely,
Justin Kobe, CFA Founder & Portfolio Manager
Advisory services through Cambridge Investment Research Advisors, Inc., a Registered Investment Adviser. Securities offered through Registered Representatives of Cambridge Investment Research, Inc., a broker-dealer, member FINRA/SIPC. Cambridge and Pacificus Capital Management are not affiliated.Material discussed is meant for general illustration and/or informational purposes only, and it is not to be construed as investment, tax, or legal advice. Although the information has been gathered from sources believed to be reliable, please note that individual situations can vary. Therefore, the information should be relied upon when coordinated with individual professional advice. These are the opinions of Justin Kobe and not necessarily those of Cambridge Investment Research, are for informational purposes only, and should not be construed or acted upon as individualized investment advice. Investing in the bond marketis subject to risks, including market, interest rate, issuer credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies is impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Diversification and asset allocation strategies do not assure profit or protect against loss.