Fasten your seat-belts everyone! The month of May 2013 has produced the 4th worst sell-off in US governments bonds in over 20-years! Rates on US 10-year government bonds have increased by almost 0,6% over the course of the month (from 1,6% to 2,15%), as market participants start pricing in a high probability of the Federal Reserve gradually removing the extraordinary liquidity they have pumped into the economy for the past 5-years. Assets such as investment grade bonds, high yield bonds, defensive equities and Emerging Market currencies, which had benefitted the most from global Quantitative Easing policies, were also the ones which gave back most gains in May.
Volatility is back in earnest and not just in the bond markets. Witness the 7,3% daily fall in the Nikkei that occurred on May 22nd as long positions all rushed together for the exit door and as Japanese Government Bonds touched 1% on the same day. Fair to say, before the correction, the Nikkei had been up +43% since the start of the year as everyone seems to believe ‘Abenomics’ will finally pay off for Japan and end the deflationary cycle for the past 20 odd years.
Let’s take a few steps back. Bernanke’s speech on May 22nd speech and Fed minutes of the April meeting showed that there is indeed a debate taking place within the Fed about when it can afford to slow down its pace of large-scale asset purchases (currently around $85bn a month). The Fed is telling us however, they won’t increase short-term interest rates before 2015. More importantly, the latest US economic data releases are not conclusive enough yet to warrant a tapering of Fed purchases before 2014. In fact the latest US activity data are indicating growth forecasts for 2013 may have to be downgraded rather than upgraded. Meanwhile, US inflation numbers have recently declined further to 1- year low levels and inflation expectations are still low.
That is why we do not expect an imminent end to easy money by the Fed, not before Q1 2014, when the recovery would have confirmed itself and growth could be comfortably above 2%. Let’s not forget, away from the US, global central banks will continue to add another few trillions to their balance sheets by the end of next year as growth remains sluggish (Japan, UK, Europe).
This fundamental view explains why we are comfortable sticking with our carry strategies, which we have been implementing in our portfolios for the past year: overweight High Yield Bonds and High Dividend Stocks. That said, these authors' experiences in the market over the past several years has taught them that one has to respect the market dynamics and that markets can overshoot. There is indeed a risk that the market’s continued anticipation of an earlier than expected end of US QE goes on for another few weeks. Which is why we have decided to increase the weight of our Equity allocation by the same proportion by which we reduced our bond allocation, in particular in high yield bonds. We believe that the best hedge against these further speculations of QE ending is to have a higher proportion of equity in our portfolio, since they still offer the highest risk premium amongst other asset classes and have much less benefitted from the ‘search for yield’ dynamics.
Despite the recent price falls on high yield bonds, we continue to think that they offer fundamental value: the high-yield default rate in April 2013 decreased to 0.99% from 1.25% in March, the lowest level for the default rate since June 2011. We expect high yield bond default rates to remain at or below 2% in both 2013 and 2014, well below their 4.2% long-term average. Even with Fed tapering on our mind, high yield spreads still constitute an attractive carry investment. Within the high yield bond universe, we are focusing on single-B rated corporate bonds from US companies with short duration as this represents the sweet spot for yield pick-up vs. underlying company leverage. Bond market new issue activity remains very healthy with no clear signs yet of predatory lending or strongly increasing leverage on behalf of the borrowers (still very healthy proportion of funds used for refinancing existing debt).
In terms of our currency allocation, we believe that a gradual tapering of the Fed’s QE program, starting only in Q1 2014 should be US Dollar-positive. The US-Dollar will also benefit from ongoing currency wars and central banks acting forcefully to weaken their currencies (JPY, AUD, CHF, EURO, ILS, etc). Our other favorite currency is the Chinese Renminbi: further steps by China to relax controls of its currency through increased convertibility, suggest the Renminbi is only in its early stage of appreciation vs. the currency majors.
As we are about to enter a period of increased volatility in financial markets, coupled with lower liquidity over the summer months, we would encourage you to get in touch with us for any questions or comments regarding our investment policy.