Economic & Market Review - October 2014

by Gavin Graham, Chief Strategy Officer October 21, 2014
Notice: This newsletter is intended as a general financial market outlook, and should not be relied on as investment advice.
September 2014 will go down as one of the worst months for world stock markets in a couple of years. Fuelled by a rise in long term government bond yields, caused by forecasts of rising short-term interest rates in North America, global stocks sold off between 2% and 5% from highs reached in the middle of this year. The broad S&P500 Index in the US fell 2.2% from its all-time high on September 18th to October 3rd, as unemployment declined to a six year low of 5.9% and 248,000 jobs were added in September, compared to an initial estimate of 215,000. The index is in fact still up 6.5% for the year to date, but this is a much weaker performance than last year's 25% gain. In Europe, the Stoxx 600 Index has slid 3.7% from a six year high reached in June, and fell 2.1% in the week ended October 3rd as concern grew that the European Central Bank (ECB)'s asset buying plan won't be enough to boost inflation and revive the region's economy.

The strong performance of the stock market this year has been rather surprising, given that the US Federal reserve has been "tapering" its Quantitative Easing (QE) bond-buying programme. It started with $85 billion a month for 2013, and has subsequently been reducing the funding by $10 billion at each of the seven meetings it has held this year. With the final $15 billion of stimulus expected to be withdrawn this month, most economists and analysts have been wrong footed as the yield on the benchmark 10 year US Treasury bond has fallen by more than 0.5% to 2.45% this year.

Most of this decline in yields can be attributed to a flight to what are perceived (rightly or wrongly) to be "safer" assets, as geopolitical tension has risen throughout the year, with the takeover of much of Iraq by the Islamic State (Isis) and Russia's conflict with Ukraine. The same phenomenon has seen German 10 year bond yields fall below 1% (a record low of 0.9%), and states in the Euro-zone such as Italy and Spain paying less than the US to borrow money for 10 years.

Whether this makes any sense to long-term investors in pension funds is another matter. One of the reasons why government bonds have done so well is that owning them does not count against a bank's capital ratios. Thus, a bank that is required to hold more share capital against its commercial and personal loans, in developed markets such as in North America, Europe and Japan, since the Financial Crisis of 2008-09, can own as many government bonds as it wishes without them counting against its capital, as the regulators regard them as "risk-free".

On the other hand, commercial loans to companies, or mortgage loans to individuals, are regarded as higher risk, and banks have to set aside a percentage of their equity against such lending. While this has always been the case, risk-averse central bankers and governments, negatively impacted by the sub-prime mortgage fiasco in North America, have raised the amount of capital required for mortgage lending. Likewise, while many companies have much stronger balance sheets than governments these days, commercial and industrial lending is also penalized more strictly than before the crisis, one of the reasons why trying to get banks to restart lending to the private sector has been very challenging.

As we have observed before, lending money to governments at nominal rates of less than 3% for 10 years or more is a sure fire way to end up losing money in real, inflation-adjusted terms. Those lenders who did so in the 1940s and 1950s, the last time bond yields and interest rates were this low, ended up regarding bonds as "certificates of confiscation", as interest rates rose to reflect higher inflation. At the moment, investors are enjoying the best of both worlds; while governments and central banks keep interest rates at 60 year lows, inflation has not risen sharply. In fact, in Europe, the worry is that deflation is more likely, hence the sharp sell-off in European stocks when it appeared the ECB's measures last week were not aggressive enough to kick-start inflation.

However, one conclusion does emerge from any study of financial history. Whatever central banks want, in the end, they will succeed in getting it. When the Fed funded the costs of the Great Society and the Vietnam War in the 1960s by printing money, they got inflation. When the Fed under Paul Volcker decided to bring inflation under control in the 1980s with punishingly high interest rates, they succeeded. Now that his successors, Ben Bernanke and Janet Yellen, have decided to support keeping asset prices high and unemployment falling, eventually this will be reflected in higher inflation. For pension fund trustees and investors, diversifying fixed income holdings away from developed market government bonds into corporate or emerging market government debt (in US dollars or other developed currencies), is a prudent course to consider.

All figures from Bloomberg October 6th, 2014?