In Friday’s Daily Reckoning I mentioned Europe’s negative interest rates and how Mario Draghi at the European Central Bank (ECB) will attempt to drive them even lower in early December. That’s when the ECB next meets.
It raises the question, is the global bond market bubble at risk of blowing up? There’s significant commentary and worry about stock markets, but not much about the risks brewing in bonds.
Consider these worrying statistics, from the Telegraph in the UK:
‘As of late November, roughly $6 trillion of government debt was trading at negative interest rates, led by the Swiss two-year bond at -1.046pc. The German two-year Bund is at -0.4pc.
‘The Germans and Czechs are negative all the way out to six years, the Dutch to five, the French to four and the Irish to three. Bank of America says $17 trillion of bonds are trading at yields below 1pc, including most of the Japanese sovereign debt market.’
It’s fair to say this is unprecedented in financial history. If central bankers get their wish and inflation starts to pick up, there will be billions of dollars of losses in the bond market.
That because when yields fall, prices rise. And when yields rise, prices fall.
In valuation terms, a bond yielding 1% trades on a P/E ratio of 100 times. A bond yielding 0.5% is on a P/E of 200 times. And you’re worried about stocks trading on a P/E of 15 times?
The scary thing about the global bond market is that it is much larger than the equity market. That’s a function of prolonged low interest rates and a massive increase in government debt issuance since 2008.
Do you remember that McKinsey study from the start of the year? It found that between 2007 and 2014, global debt levels had increased by US$57 trillion. That is a huge increase.
And such is the demand for this ‘safe’ asset, the market has easily absorbed this issuance and bid up the price at the same time. That’s frightening.
I’m not sure where the tipping point is for the global bond bubble. It depends on what happens with inflation. If the rest of the world goes the way of Japan and enters a long, slow, deflationary phase, then bond prices will stay elevated for many years.
But if inflation heats up and then gets away from central bankers, trillions of dollars will go up in smoke as capital escapes the bubble bust.
Where will capital go? Property, equity markets? According to this Telegraph article, prime property will benefit:
‘The Norwegian Pension Fund, the world’s top sovereign wealth fund, is rotating a chunk of its $860bn of assets into property in London, Paris, Berlin, Milan, New York, San Francisco and now Tokyo and East Asia. “Every real estate investment deal we do is funded by sales of government bonds,” says Yngve Slyngstad, the chief executive.’
This lends weight to Phil Anderson’s Cycles Trends and Forecasts theory that global property markets will experience an almighty boom into 2026. This makes sense if inflation starts to pick up and big pension funds want an inflation hedge.
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Stock should also do well from capital getting out of bonds. After all, in the world of finance, everything is relative.
But if inflation gets out of control, I wouldn’t want to bet on stock markets doing too well either.
Think of the world’s balance sheet. There’s a lot more debt than equity, meaning the global economy is highly geared. This boosts growth and return on equity when times are good.
But if inflation picks up strongly it will erase real economic growth. A lack of real growth means lower returns on equity. In such an environment, global bond AND stocks markets will get smashed.
I’m not sure how far away a pick-up in inflation is. Bond markets certainly don’t seem too concerned about it right now. The good news is, if you know where to look, you’ll see it coming.
You just need to read charts every now and then. Actually, I mean look at them. But look at them properly…analytically.
Take the recent share price action of listed law firm Slater and Gordon. In recent weeks, its share price has collapsed. Have a look at the chart below. As you can see, the share price began to move lower before the negative announcement.
That is, the market knew something was brewing before Slater and Gordon released the news to the ASX. In fact, the share price lost around 40% of its value prior to the release.
Let’s leave aside the irony of a law firm issuing an announcement after its share price had already collapsed (continuous disclosure, anyone?) and focus on the point.
That is, the market will generally give you clues about coming moves. With Slater and Gordon, for example, you should have sold when the stock price broke below $2.50. That was a break to new lows and a sign that all was not well.
A few days later the negative announcement about regulatory changes in the UK vindicated that sign.
The message here is that the market will generally always give you a clue of impending moves if you know how and where to look. Of course, it’s not fool proof. Sometimes the market throws of false signals.
But if you want to improve your odds, always listen to what the market is saying before you act. It’s much smarter than you, so pay attention.
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