27 June to 1 July: Stagnation Revisited

At the beginning of 2016, US Treasuries for 5, 10 and 30 years traded at 1.76%, 2.27% and 3.01% respectively – broadly the lowest levels on record.  Given the FED had just raised rates in December (for the first time since 2006), and was messaging a hiking cycle, the casual observer would then surely have judged it eye watering to be carrying large fixed income holdings.

Fast forward, and this week saw new records with the 5, 10 and 30 year Treasuries yielding 1.00%, 1.46% and 2.24%. This means long-dated US Government bonds are one of the best performing major market segments – the S&P BGCantor 20+ Year Treasury Index is up 17.47% YTD. And the trend is not unique, last week every Swiss government bond in issue, and the German and Japanese 10yr bonds, traded sub-zero.

We think these dynamics are important for a number of reasons:

• It’s not about Brexit: to state the obvious, pan flat and all-time low yield curves are screaming “long-run growth problem”. Whether you believe it is demographics, over-leverage, inequality, bad policy or falling innovation, bond markets cannot see a path back to “normal” growth and inflation. Thus, even in the UK, Brexit is at most a very small part of an overarching economic issue. Indeed, we repeat that whilst the short-term effects of the referendum result are negative (uncertainty and potential negative spill overs), the long-run implications can very well be positive – depending on forthcoming negotiations.
• Policy is going to change: the US may have made some progress in repairing balance sheets, but it is insufficient to return to pre-crisis productivity growth or normalised rates. In Europe and Japan we have arguably only moved backwards. Therefore, we should expect central bank responses to evolve – perhaps nominal GDP targets, higher inflation targets or helicopter money.
• Asset allocation: classic portfolio construction rules give that a “safe” allocation focuses on government bonds, whereas higher risk results from equities and emerging market exposure. Is that really true now? Developed market government bonds offer zero yield, ambiguous correlation with equity markets and price in basically no growth or inflation indefinitely. Instead, many emerging markets are under-owned and offer a genuine growth story with young populations and a structural transformation towards higher value sectors.

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