Over the past few months, we’ve been suggesting the 10 year bond yields in the US will eventually fall well below 2% p.a.
The scenario that we based this outlook on continues to play out as we expected:
1. China’s deteriorating economy and the market’s lack of faith in the transparency of their government data will create market volatility and ultimately an equity market correction, particularly in the US and Australia:
a) Market wobbles started in July and August. Some of Wall St’s biggest losing streaks in history followed, and US 10 year bond yields fell below 2%p.a.. Then the inevitable rebound and subsequent severe volatility started. Things have calmed again now, but there will be much more volatility over the coming months, either driven by more bad news from China or by the Fed eventually increasing rates.
b) Economic data out of China in August was uniformly disappointing from exports to fixed asset investment.
2. US Equities are at historic highs in terms of long-term PE ratios (if equities correct, bond yields tend to fall):
a) Wall Street has corrected a little since our original call on this point, the long-term PE ratio published by Robert Shiller at Yale University, in our view the most reliable indicator of long-term value, remains at 25, compared to its average of 17. In 2000 this ratio hit 40 and then fell to 13 in the dotcom crash.
b) Equally concerning is the investor confidence survey published by Yale as well. This shows a dangerous convergence of investor having low confidence in value, but moderate confidence in short-term pricing, ie they don’t believe markets are good value, but believe they will be able to get out before they correct. The same inconsistent confidence occurred last in 1999/2000.
3. The AUD will fall on concerns about China and eventually hit the 65-70c range, worsening further in the event that China’s economy falls suddenly:
a) The AUD fell below 70c during August’s volatility and is now trading between 69 and 72 cents.
b) The AUD is amongst the worst five performing investments in the world over the past 12 months, sitting alongside some interesting company: the Brazilian Real; the Russian Ruble; Turkish Lira and the New Zealand Dollar. The AUD is a proxy for emerging market currencies and will continue to fall as confidence in emerging markets falls.
4. The EU and Japan will extend their currency wars, putting downward pressure on the US Fed to be more patient:
a) The EU came out with a statement early September confirming that they are open to extending their QE (Quantitative Easing) program
b) Japan is yet to make such a statement openly, but their economic data has been very poor so we expect such an announcement to be imminent
5. Deflationary pricing pressures, including the impact of the currency wars, will mean all central banks will fall short of the inflation targets:
a) US wage growth is still below target, despite their strengthening economy.
b) UK inflation has fallen back to zero, again despite a healthy economy overall.
c) Oil prices remain low as the stand-off between the US and OPEC continues. The risk for oil prices is still on the downside, particularly once storage capacity around the world is filled up, leaving producers no choice but to cut production.
d) Food prices have also fallen steeply in recent months, keeping inflation at bay, although we don’t expect this trend to continue as food prices are far more subject to weather related shocks.
6. The US economy, while the world’s most robust at the moment and recovering well, will not return to long-term averages and will fall short of the market’s expectations:
a) The market is still expecting GDP growth of 2.5% in 2015. The first half of the year was 1.8%p.a. growth (in other words the economy grew by 0.9% in that six month period).
b) We expect Q3 GDP growth to disappoint markets again, coming in at around 1.6% to 1.8%. Data released yesterday confirmed that inventory build ups and government spending spikes included in the Q2 GDP figures will reverse in Q3.
US 10 year bond yields have traded in a range of 1.9% to 2.45% over the past three months. As of last night, they were back to 2.29%. Last time they were at this level, we called them very good value and make the same call now for the same reasons, as above. The market is busily watching the Fed’s meeting this week and agonising over whether they increase rates this month or in December. For long-term investors, that doesn’t matter. What matters is how high they eventually raise rates. In the face of the above economic outlook, we believe the Fed will increase rates very lightly in the next cycle, stopping well short of 2%, meaning that the 10 year bond yield is good value above 2%p.a. At today’s rate of 2.29% p.a., anyone that has been considering taking more USD corporate bond positions should look for good value names before the Fed decision later this week, particularly with the AUDUSD rate above 70 cents.