It’s getting hot in here
Global bond yields are the lowest they’ve been in 500 years. And, around the world, there are $10 trillion of negative rate bonds. This situation has prompted legendary US investor, Bill Gross, to comment: “this is a supernova that will explode one day”. So, how concerned should we be?
Several of the Montgomery team, including CEO David Buckland, Chris Demasi, Ben MacNevin and your author have written extensively about the stunning decline in bond yields, which is occurring despite terrorist attacks, political turmoil in the UK, violence in the US and the prospect of ‘last resort’ helicopter money in Japan.
Since the Fed raised rates in December 2015 (usually a sign the economy is strengthening), US 10-year government bond yields have fallen from 2.3 per cent to 1.47 per cent.
Traditionally, a rising stock market has signalled an improving economy while falling bond yields signalled deflation or disinflation, implying the virtual certainty of a recession. We have both. Tradition doesn’t apply when the source of the declining bond yields aren’t regular investors but massive, globally coordinated central banks. One must ask whether the signals we, as equity investors, are used to seeing are being obscured by ‘official’ central bank activity? Are investors unwitting frogs in a pot full of now simmering water?
According to one report, 30 per cent of global sovereign bonds, or about US$13 trillion of the US$43 trillion, are carrying negative yields. In another report by Deutsche bank, US$15 trillion or 40.5% of the US$37 trillion in developed market sovereign bonds are carrying negative yields and 80 per cent are carrying yields of less than 1 per cent.
Think about that for a moment.
If you lend CHF100,000 to Switzerland for 30 years – by purchasing a 30-year Swiss bond – you will receive CHF96,172 30 years from now. The same thing happens if you lend money to the governments of Germany and Japan for 10 years. The list over five years includes the aforementioned countries as well as Netherlands, Finland, Austria, Denmark, Belgium, France, Sweden and over two years you can add Ireland, Spain and Italy to the list.
And that last country is interesting. Italy’s banking system is in crisis and in need of a bailout. It is estimated Italy’s banking system is harbouring US$400 billion of problem loans or 25% of the country’s GDP. Despite this, the country can now borrow at lower rates than when times were good.
All of this of course has been driven, not by the weighing scales of the market’s price discovery process, but by heavy-handed central banks. The combined central bank balance sheets of Switzerland, the UK, the ECB, the US and Japan have grown from US$3.5 trillion in 2007, to US$12.5 trillion today.
The justification for many equity investors to be fully invested is that the earnings yield on equities is more attractive than bond yields. But if bond yields are an artifice created by central bank buying, should they be the benchmark against which we measure the attractiveness of stocks?
As John Authers wrote in the Australian Financial Review on 18 July 2016, “there is no enthusiasm, but ever pricier bonds leave no choice but to buy stocks…Is this a secure basis on which to invest? No….Anyone trying to make money or preserve capital must be calm and relaxed.”
Bill Gross the founder of the Janus Global Unconstrained Bond Fund perhaps summed it up best: “Global yields lowest in 500 years of recorded history. $10 trillion of negative rate bonds. This is a supernova that will explode one day.”
Roger Montgomery is the founder and Chief Investment Officer of Montgomery Investment Management. To invest with Montgomery, find out more.
Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
Andrew Wright
:
Isn’t gold the usual safe haven when all else fails? So yes, commodities.
Brian
:
This supernova is special, despite investment perspectives that lend a Buffett’s assurance.
The pain that could be felt, when this all goes wrong, is potentially extreme.
This isn’t only an exuberance by a single nation, like say the US’s once economic banking solo reaching a high irrationality, but the full orchestra of world nation’s marching in banking tandem insanity.
We have no history for this. There is no insightful thinking of where the world’s banks are right now.
Old forgotten theorist are being called forward, but none seem to know. As known today understand where there world is ‘at’, today.
All the nations of the world’s have almost all allowed themselves to chase their currencies to impossible lows to stave off national trade deficits.
Almost everyone realises the world’s banking is an extreme zone. A zone never charted. But no one thinker or central bank seems to know how to unwind the crazy ‘contango’
Well at least, none that I know of.
When the interest rate mechanism fails to support it’s rate at levels that will allow the parsing of capital into EITHER investment OR debt, then the world’s economics as we know & understand it fails.
All we know is, as debt & investment asset’s prices levitate ever upwards together, that they will as likely, ultimately probably collapse together too.
And that leaves both prudent investors and cautious savers across the wide world, naked to protect them selves.
WHEN the supernova implodes.
Are we there yet?
Yes…
Roger Montgomery
:
Eloquently put Brian
Kelvin Ng
:
Hi Roger, I actually think that its very unlikely that debt and investment assets’ prices will collapse together. When sovereign bonds collapse, which I agree they will (but who knows when), where will the big money go? Bonds are by far the largest asset class in the world. As capital flees from sovereign bonds and also from Europe (the Euro will collapse as well), where will funds park their money? In cash in bank accounts or with trillions under mattresses? I believe they will push US stocks up, as a safe haven. Almost certainly, bond like stocks (i.e. pure dividend yield plays, utilities etc. with no growth) will fall as well, but the rest will go up. There is then really TINA (there is no alternative).
Kelvin
Roger Montgomery
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Unlikely to go into stocks if bond yields are rising.
Kelvin Ng
:
Where do you think they will go?
Roger Montgomery
:
I myself don’t know but one view I have heard is commodities.
Kelvin Ng
:
Thanks Roger. I think one good way to play the bursting of the sovereign bond bubble at some point in the future is to be long US large cap growth stocks like Amazon, Apple, Google, and Visa, and short defensive yield stocks. That way you should be covered. Even if the stock market falls as a whole, the yield plays should fall more.
Kelvin
LJ Ferguson
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I have read that excert multiple times before but goodness me its good advice for accumulating wealth and not stressing yourself out with things you cant control along the way.
Chris
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“The goal of the nonprofessional should not be to pick winners…but should rather be to own a cross section of businesses that in aggregate are bound to do well. A low-cost S&P 500 index fund will achieve this goal.”
And there is part of your problem, because right now, the S&P500 is very overvalued on several measures.
Andrew Wright
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Granted, that is the problem and it is a big problem; what is the solution? How do we react? Is it time to invest in seeds, a shovel and cement and start constructing a fall out shelter (only said half in jest)?
Roger Montgomery
:
That sounds extreme Andrew.
Kelvin Ng
:
Hi Roger, here’s the latest from Jeremy Grantham – he’s still bullish:
https://www.gmo.com/docs/default-source/research-and-commentary/strategies/asset-allocation/immigration-and-brexit.pdf?sfvrsn=9
Richard
:
Spot on Roger.
Its like we move from two behavioural situations in the economic world.
1) Where everyone with some intelligence can see that the current fiat system of the world with CB support is ultimately unsustainable and will inevitably have to change (most likely with some unrest).
2) Central banks then calm us down and pause, delay or state they need to do more and we carry on with the rally. Quality and yield gets well bid and we move through to the next volatile period of more issues from Europe, Chinese debt/growth, Japan QE, US raising rates, etc.
Rinse and repeat.
The next can-kicking episode seems like it will be helicopter money to maintain the status quo and further widen the inequality gap.
In the end we will sit back and realise that ZIRP and easy monetary policy is an unproven growth tool and the world actually needs to correct itself for longer term sustainability. Otherwise we go through this japan-like global situation for many years, which seems crazy but is more probable than a collapse involving gold, lead, bunkers and canned food.
Frustratingly, timing for the explosion of the supernova is a very low probability game.
Roger Montgomery
:
Indeed it is. Stick to owning high quality businesses and buy more when prices are attractive.
Mark Egan
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Hi Roger, thanks for your summation of the weirdness of the current markets but it begs the following question. If the answer is that I should not benchmark stock attractiveness to artificially low bond rates and I stay calm and relaxed while waiting for a supernova to explode where do you suggest I invest my life’s savings?
Cheers,
Mark
Roger Montgomery
:
See the Buffett Letter excerpt here in the comments…
Mark Egan
:
Hi Roger,
Buffett bought the farm after “the bubble burst” and the 1993 property after “a bubble popped”. The supernova has not yet exploded.
Roger Montgomery
:
Many of us have already bought at much lower prices too. And it was business as usual for Buffett after that (i.e. continued acquiring).
carl.poingdestre
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The central banks keep selling bonds that nobody wants and the banks keep clipping the ticket.
Paul T
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At times like this what do us investors do? Do we stick to our guns and invest in great companies at reasonable prices or do we get out at the fear of a supernova exploding one day? What is the master (Buffett) doing at the moment?
I’m guessing it’s business as usual for him.
Roger Montgomery
:
Business as usual. Here’s Buffett’s 2013 Annual letter excerpt: This tale begins in Nebraska. From 1973 to 1981, the Midwest experienced an explosion in farm prices, caused by a widespread belief that runaway inflation was coming and fueled by the lending policies of small rural banks. Then the bubble burst, bringing price declines of 50% or more that devastated both leveraged farmers and their lenders. Five times as many Iowa and Nebraska banks failed in that bubble’s aftermath as in our recent Great Recession.
In 1986, I purchased a 400-acre farm, located 50 miles north of Omaha, from the FDIC. It cost me $280,000, considerably less than what a failed bank had lent against the farm a few years earlier. I knew nothing about operating a farm. But I have a son who loves farming, and I learned from him both how many bushels of corn and soybeans the farm would produce and what the operating expenses would be. From these estimates, I calculated the normalized return from the farm to then be about 10%. I also thought it was likely that productivity would improve over time and that crop prices would move higher as well. Both expectations proved out.
I needed no unusual knowledge or intelligence to conclude that the investment had no downside and potentially had substantial upside. There would, of course, be the occasional bad crop, and prices would sometimes disappoint. But so what? There would be some unusually good years as well, and I would never be under any pressure to sell the property. Now, 28 years later, the farm has tripled its earnings and is worth five times or more what I paid. I still know nothing about farming and recently made just my second visit to the farm.
In 1993, I made another small investment. Larry Silverstein, Salomon’s landlord when I was the company’s CEO, told me about a New York retail property adjacent to New York University that the Resolution Trust Corp. was selling. Again, a bubble had popped — this one involving commercial real estate — and the RTC had been created to dispose of the assets of failed savings institutions whose optimistic lending practices had fueled the folly.
Here, too, the analysis was simple. As had been the case with the farm, the unleveraged current yield from the property was about 10%. But the property had been undermanaged by the RTC, and its income would increase when several vacant stores were leased. Even more important, the largest tenant — who occupied around 20% of the project’s space — was paying rent of about $5 per foot, whereas other tenants averaged $70. The expiration of this bargain lease in nine years was certain to provide a major boost to earnings. The property’s location was also superb: NYU wasn’t going anywhere.
I joined a small group — including Larry and my friend Fred Rose — in purchasing the building. Fred was an experienced, high-grade real estate investor who, with his family, would manage the property. And manage it they did. As old leases expired, earnings tripled. Annual distributions now exceed 35% of our initial equity investment. Moreover, our original mortgage was refinanced in 1996 and again in 1999, moves that allowed several special distributions totaling more than 150% of what we had invested. I’ve yet to view the property.
Income from both the farm and the NYU real estate will probably increase in decades to come. Though the gains won’t be dramatic, the two investments will be solid and satisfactory holdings for my lifetime and, subsequently, for my children and grandchildren.
I tell these tales to illustrate certain fundamentals of investing:
You don’t need to be an expert in order to achieve satisfactory investment returns. But if you aren’t, you must recognize your limitations and follow a course certain to work reasonably well. Keep things simple and don’t swing for the fences. When promised quick profits, respond with a quick “no.”
Focus on the future productivity of the asset you are considering. If you don’t feel comfortable making a rough estimate of the asset’s future earnings, just forget it and move on. No one has the ability to evaluate every investment possibility. But omniscience isn’t necessary; you only need to understand the actions you undertake.
If you instead focus on the prospective price change of a contemplated purchase, you are speculating. There is nothing improper about that. I know, however, that I am unable to speculate successfully, and I am skeptical of those who claim sustained success at doing so. Half of all coin-flippers will win their first toss; none of those winners has an expectation of profit if he continues to play the game. And the fact that a given asset has appreciated in the recent past is never a reason to buy it.
With my two small investments, I thought only of what the properties would produce and cared not at all about their daily valuations. Games are won by players who focus on the playing field — not by those whose eyes are glued to the scoreboard. If you can enjoy Saturdays and Sundays without looking at stock prices, give it a try on weekdays.
Forming macro opinions or listening to the macro or market predictions of others is a waste of time. Indeed, it is dangerous because it may blur your vision of the facts that are truly important. (When I hear TV commentators glibly opine on what the market will do next, I am reminded of Mickey Mantle’s scathing comment: “You don’t know how easy this game is until you get into that broadcasting booth.”)
My two purchases were made in 1986 and 1993. What the economy, interest rates, or the stock market might do in the years immediately following — 1987 and 1994 — was of no importance to me in determining the success of those investments. I can’t remember what the headlines or pundits were saying at the time. Whatever the chatter, corn would keep growing in Nebraska and students would flock to NYU.
There is one major difference between my two small investments and an investment in stocks. Stocks provide you minute-to-minute valuations for your holdings, whereas I have yet to see a quotation for either my farm or the New York real estate.
It should be an enormous advantage for investors in stocks to have those wildly fluctuating valuations placed on their holdings — and for some investors, it is. After all, if a moody fellow with a farm bordering my property yelled out a price every day to me at which he would either buy my farm or sell me his — and those prices varied widely over short periods of time depending on his mental state — how in the world could I be other than benefited by his erratic behavior? If his daily shout-out was ridiculously low, and I had some spare cash, I would buy his farm. If the number he yelled was absurdly high, I could either sell to him or just go on farming.
Owners of stocks, however, too often let the capricious and irrational behavior of their fellow owners cause them to behave irrationally as well. Because there is so much chatter about markets, the economy, interest rates, price behavior of stocks, etc., some investors believe it is important to listen to pundits — and, worse yet, important to consider acting upon their comments.
Those people who can sit quietly for decades when they own a farm or apartment house too often become frenetic when they are exposed to a stream of stock quotations and accompanying commentators delivering an implied message of “Don’t just sit there — do something.” For these investors, liquidity is transformed from the unqualified benefit it should be to a curse.
A “flash crash” or some other extreme market fluctuation can’t hurt an investor any more than an erratic and mouthy neighbor can hurt my farm investment. Indeed, tumbling markets can be helpful to the true investor if he has cash available when prices get far out of line with values. A climate of fear is your friend when investing; a euphoric world is your enemy.
During the extraordinary financial panic that occurred late in 2008, I never gave a thought to selling my farm or New York real estate, even though a severe recession was clearly brewing. And if I had owned 100% of a solid business with good long-term prospects, it would have been foolish for me to even consider dumping it. So why would I have sold my stocks that were small participations in wonderful businesses? True, any one of them might eventually disappoint, but as a group they were certain to do well. Could anyone really believe the earth was going to swallow up the incredible productive assets and unlimited human ingenuity existing in America?
When Charlie Munger and I buy stocks — which we think of as small portions of businesses — our analysis is very similar to that which we use in buying entire businesses. We first have to decide whether we can sensibly estimate an earnings range for five years out or more. If the answer is yes, we will buy the stock (or business) if it sells at a reasonable price in relation to the bottom boundary of our estimate. If, however, we lack the ability to estimate future earnings — which is usually the case — we simply move on to other prospects. In the 54 years we have worked together, we have never forgone an attractive purchase because of the macro or political environment, or the views of other people. In fact, these subjects never come up when we make decisions.
It’s vital, however, that we recognize the perimeter of our “circle of competence” and stay well inside of it. Even then, we will make some mistakes, both with stocks and businesses. But they will not be the disasters that occur, for example, when a long-rising market induces purchases that are based on anticipated price behavior and a desire to be where the action is.
Most investors, of course, have not made the study of business prospects a priority in their lives. If wise, they will conclude that they do not know enough about specific businesses to predict their future earning power.
I have good news for these nonprofessionals: The typical investor doesn’t need this skill. In aggregate, American business has done wonderfully over time and will continue to do so (though, most assuredly, in unpredictable fits and starts). In the 20th century, the Dow Jones industrial index advanced from 66 to 11,497, paying a rising stream of dividends to boot. The 21st century will witness further gains, almost certain to be substantial. The goal of the nonprofessional should not be to pick winners — neither he nor his “helpers” can do that — but should rather be to own a cross section of businesses that in aggregate are bound to do well. A low-cost S&P 500 index fund will achieve this goal.
That’s the “what” of investing for the nonprofessional. The “when” is also important. The main danger is that the timid or beginning investor will enter the market at a time of extreme exuberance and then become disillusioned when paper losses occur. (Remember the late Barton Biggs’s observation: “A bull market is like sex. It feels best just before it ends.”) The antidote to that kind of mistiming is for an investor to accumulate shares over a long period and never sell when the news is bad and stocks are well off their highs. Following those rules, the “know-nothing” investor who both diversifies and keeps his costs minimal is virtually certain to get satisfactory results. Indeed, the unsophisticated investor who is realistic about his shortcomings is likely to obtain better long-term results than the knowledgeable professional who is blind to even a single weakness.
If “investors” frenetically bought and sold farmland to one another, neither the yields nor the prices of their crops would be increased. The only consequence of such behavior would be decreases in the overall earnings realized by the farm-owning population because of the substantial costs it would incur as it sought advice and switched properties.
Kelvin Ng
:
Hi Roger, the contrary view is that while global bond yields are indeed a supernova that will explode one day, no one knows when, including Bill Gross. He famously sold out of all US Treasuries in 2011 (while at PIMCO). When you’re that early, its indistinguishable from being wrong. As Kyle Bass said in a recent interview, part of the job of an investor these days is to handicap central banks, and they look like they’re stubborn enough and crazy enough to go for helicopter money. Its coming. As he said, this is not the most intellectually pure or satisfying approach to investing, but its the reality.
The quote from John Authers in the AFR is telling – “there is no enthusiasm” – that’s exactly right, wait till there is great enthusiasm from the retail investors!
Kind regards,
Kelvin
Roger Montgomery
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Not knowing when something ‘will’ happen is not contrary though. Indeed of all thievery large market corrections, they were without exception preceded by a period of optimism.
Kelvin Ng
:
Ok. But given timing is so uncertain, and the supernova could explode in 3 months or in 3 years (I’d suggest more likely in 3 years, given the option of helicopter money by central banks), in which time the US stock market could have another huge leg up, how do you size the position of the short portfolio in the Montaka Fund? The Warren Buffet story above doesn’t help here, as he’s not talking about shorting.
Kelvin
Roger Montgomery
:
Business as usual Kelvin. That’s the point of Buffett’s letter. Business as usual means following our long process and business as usual applying the shorting framework.
Kelvin Ng
:
Thanks Roger. As long as you don’t use the belief that there’s a supernova explosion in the offing in sizing your short portfolio, that’s fine.