Letter To Investors: Investing Towards The End Of The Great Bond Bubble
In past letters, we have consistently held that the current economic cycle, the resultant investment environment and behaviour of financial markets are unlike anything seen in living memory. Consequently, the outlook for asset prices is extremely hard to predict. Whilst we maintain our view that good quality Australian and overseas listed companies will deliver attractive returns over a long period, we remain cautious concerning the short term outlook for asset markets in general.
The following is an insight into our present thought processes. It outlines our particular concern for the bond market and the ramifications of the likely adjustment of the “risk free rate of return” from which all assets are priced.
If our position resonates, then like us you should remain patient and resolute in your investment endeavours. Our (and your) aim should be to continue to seek a realistic return from the equity market over time, but to do so without undertaking excessive risk.
At Clime, we approach our role as investment managers somewhat differently from most other Australian managers. We do so not because we are smarter than our peers; rather, we are not hamstrung by investment rules that we think are inappropriate for generating sustainable returns or preserving capital. Our focus is on achieving an “absolute” return for our clients. We will not chase “relative” short term returns because they are meaningless.
Ultimately, wealth is created by employing patience, common sense and the powerful effect of compounding. We admit that we do not always understand the behaviour of markets, and so it is axiomatic to us that being fully invested during times of uncertainty is simply foolish.
The most telling rule that inhibits most managers from creating long term wealth for their clients (rather than themselves), is that they must be fully invested at all times. No matter if they do not perceive value or understand either the investment climate or the economic environment – they stay fully invested. It is being wedded to this edict that will ultimately deliver a mediocre investment return for their clients over a long period of time.
Today the edict for full investment is everywhere but it is particularly on display across bond portfolios. In our view the disastrous ramifications of this approach will surely be seen in coming years, as the greatest bond market bubble of all time ultimately corrects. Despite this prediction, there are many bond managers who have little choice but to continue to buy bonds; there are many banks, insurance companies and pension funds that must stay fully invested. From this point, these bonds will at best give them an inferior return and at worst could ultimately cause massive loss. Once bonds correct, every other asset class will be subject to a reassessment of value.
Indeed, it will be the unfolding of the “great bond market bubble” in the early part of the twenty first century that will represent the historic mark of this period. In the past, global asset markets have seen many bubbles develop and implode. History shows that asset price bubbles have always gone far beyond what was either logical or explainable. Towards the end, it is stupidity and greed that pushes market prices to extreme levels. Then, as the bubble moves larger, there will be those who claim their returns are bigger than the bubble itself. They attract further capital from investors who just cannot “miss out”. Recall the internet bubble of 1999 for a recent example of this phenomenon.
Ultimately, bubbles only create wealth for those who can see the bubble for what it is and are able to exploit the opportunities it creates.
Do not be fooled – this is a crazy bond market
In recent months there has been no respite in the rally of European and Japanese bond prices. In recent days, longer dated US bonds have also begun to rally. This has surprised us and clearly our past warnings that bonds would correct has not occurred. However, a rally in prices does not mean that our logic is wrong. Rather, it could mean that mispricing has become more extreme. Our view is that European, Japanese and US bonds are extremely overpriced.
Recently bond yields have fallen dramatically. For instance, in the last month in Germany, we have seen negative two year bond yields and ten year bond yields falling below 1%. These are yields for German bonds that have never been seen before. Incongruously, these bond yields have occurred against a backdrop of massive Euro government debt, poor economic growth, high unemployment, unstable budgets and the omnipresent risks of default or inflation.
Figure 1. Selected ten-year government bond yields (a)
(a) Yields to maturity on ten year benchmark government bonds
When observing a bond rally, we see both higher bond prices and lower yields. It is the lower yield to maturity (or income) of a government bond – the “risk free return”- that affects the required return of all other assets. That is because government bond returns are notionally regarded as risk free (or the default investment) at times of economic stress.
Equities are a much riskier asset than bonds and so the required return from holding equity is necessarily much higher. This is true for all other asset classes as well, and so the projected return from a bond should dictate the required return from so-called riskier assets.
Why bonds are over-priced at present?
Figure 2. Core Inflation – Advanced Economics*
Source. Thomson Reuters
You may be wondering as to why we are so strident in our view of the mis-pricing of bonds. Quite simply the yields on European, US and Japanese bonds do not protect a bond owner against inflation. Today in Japan we can see that 10 year bonds yield just 0.6% per annum and yet inflation has recently reached 2%.
Not only do the yields on bonds not compensate for inflation; they do not compensate for the risk of default.
As a result it is becoming clear to us that investors are also now accepting lower compensation or potential returns from equities. The pressure for bond managers to seek higher yields by buying longer dated bonds is the same pressure felt by investors who compensate for lower cash returns by buying equities.
We should not forget that equities are perpetual securities – they are not redeemed and have no set termination date. Their price is set by market forces that are driven by financial logic, greed, indifference and sentiment. Overall a toxic mix that in the short term makes price movements impossible to forecast.
However, to a value investor’s advantage, over a longer period it is always financial performance that will move prices of equities to their true value.
The investing conundrum
But what happens to required returns when bond yields move towards negligible returns and well below inflation? Should investors merely accept lower returns for all other assets, or should they question the integrity or logic of the market and therefore stand back, hold cash and wait?
This is the present predicament for value based investors, and a confronting investment climate for self-directed retirees. By how much should we (for our clients) compromise the desired return that we seek from equities? We have conviction in our view that we should not accept the lower longer term returns that will result from ignoring risk and overpaying for equities priced off nonsensical bond yields.
Our suggested investment approach
As mentioned earlier, it is virtually impossible to predict the short term direction of markets and that may seem a justification for simply investing for the long term and forgetting about value. It may also be seen as a justification to trade momentum. However, to benefit from this requires conviction to continually take profits without a concern for value. It would also require some luck in avoiding the sharp market corrections that are likely to occur in coming years.
Our approach is to adopt a rational approach to investing capital. The key ingredients of this approach are as follows:
1. Seek a high return from equity investments irrespective of the non-sensical yields in bond or cash markets;
2. Be patient and defer to cash until opportunities become available;
3. Be prepared to be contrarian and avoid investments which are popular;
4. Focus a portion of capital on deep value cyclical opportunities;
5. Have a realistic target for investment returns. We have an absolute return target of 10% for our total portfolio that encompasses equities, listed hybrid securities, offshore equities and cash;
6. Focus (but not exclusively) on investments which produce solid and growing income returns. Remain conscious of the value of income in a world where capital values may be corrupted by low risk free returns;
7. Allow compounding of returns so long as the assets are not excessively over priced. This is best achieved by reinvestment of income at opportune times;
8. Seek appropriate offshore exposure to companies that offer access to the Asian consumer and away from the ageing and debt-riddled developed world; and
9. Acknowledge that the likely correction in international bond yields will at some point take pressure off the A$ and allow it to drift back to lower levels.
Once again, our letter is full of caution. The creation and maintenance of wealth for our clients is our paramount consideration. We do so in a diligent and transparent fashion and we do not hide our mistakes nor crow about our successes.
Investing is about ensuring that capital grows at a much faster rate than the cost of living so that real wealth is created. In most years and through most periods, this will be a fairly simple task. However today, when cash rates and bond yields have fallen below inflation, this fundamental investment task has suddenly become far more difficult. Whilst asset prices, particularly equities, have sprung higher, it is clear that most of this revaluation is due to lower and unsustainable bond yields.
Investors in Clime funds and portfolios can rest assured that we have incorporated the above “key investment ingredients” in structuring your investments appropriately. While we cannot guarantee returns, we can say with confidence that the benefit of caution, prudence and experience has informed the construction of portfolios. We are extremely well positioned and we stay well informed to predict and withstand any market correction.
Time will tell whether our cautious approach is warranted. If we can achieve a steady 10% return on our portfolios whilst not taking excessive risk for our clients, then we will have achieved our set task. That is the way we intend to invest. Slow and steady – but with an eye on the bond market bubble which many chose to ignore.
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John Abernethy is the Chief Investment Officer (CIO), Executive Director of Clime Investment Management (Clime Group) and Chairman of Clime Capital Limited.