Axa IM’s Iggo expects yields to remain low
In his latest outlook, Chris Iggo, CIO Fixed Income at Axa IM, points to reasons why yields will remain depressed.
• Yields to stay low – The conditions that have driven bond yields to historically low levels will only dissipate slowly over the next year. Under the most likely scenario we will continue to be faced with a low yield environment overall, with bond investors finding it increasingly difficult to exploit new opportunities to secure a return that is significantly in excess of current yields. But equally, it is hard to see why there would be a bear market in bonds any time soon. I always resist the argument that there is a bubble in bonds – the outperformance of the safer more senior capital instrument is usually a sign of there being a complete absence of “irrational exuberance”. Bonds may not offer great value in terms of the absolute total return or in terms of their real yields, but we do live in a world of low growth. Unless things change, the arguments for why yields will remain low are also applicable to why corporate earnings growth might be somewhat disappointing and thus why there is unlikely to be a massive asset allocation shift out of bonds into equities. That is not to say equities can’t outperform core bond markets in the coming year – it would be disappointing if they didn’t given the level of yields and the support that is being provided to the financial markets by central banks – but it’s hard to see the growth environment being strong enough to see both interest rates and equities markets go up.
• China’s new growth model – We’ve been thinking about China a bit this week, provoked by some interesting data and a fascinating meeting with a China economist. First the data. In the third quarter of the year, real GDP increased by 7.4% compared to a year earlier and by 2.2% compared to Q2. Most China watchers think that this probably marks the bottom of the cycle. Other data would seem to substantiate this view – export growth increased strongly in September, industrial output increased by 9.2% compared to a year earlier and retail sales growth was 14.2%, confirming a pick up in consumption from the summer. It is certainly good news for the global outlook if the Chinese growth deceleration that began in 2010 has come to an end. Certainly exports from other Asian economies also appear to have bottomed out. If this is a reliable indicator of the health of global trade, we should also see some better numbers from purchasing manager surveys in the US and Europe in coming months. All the better for keeping the current buoyant mood in markets going through year-end.
• No more 10% – the more interesting discussion, however, was about what Chinese growth is likely to be in the future. If you look at a chart of GDP growth over the last decade or so there is a picture emerging that the current level of growth is much more consistent with China’s potential. It seems that the policy and academic community in Beijing also think that potential growth is more like 7-8% than 10-12%. After 2002 growth accelerated from the 7%-8% range and averaged 10% in the years 2003 to 2007. The financial crisis hit world trade hard and China’s growth rate slowed to 6.8% in 2008 before bouncing back to 10.7% in 2009 on the back of a huge programme of fiscal stimulus. It has been slowing since and it seems prudent that investors in the west, when thinking about the China effect, should factor in this new growth range rather than the eye watering pace of expansion of a few years ago.
• Employment and inflation – There has been some expectation in the west that Beijing would announce another series of fiscal and monetary steps to boost the economy. However, it seems unlikely unless there is a sharp deterioration in the labour market. The rate of GDP growth is not going to be the trigger for stimulus, but a rise in the unemployment rate would be. The argument now is that with labour shortages evident in some sectors and wages rising rapidly, the economy is growing at a rate that is consistent with its potential – anything faster would lead to inflation and stresses in labour and product markets. And this brings into play other issues. For much of the last two decades, rates of capital investment have been very strong and a lot of it has been state directed in heaving manufacturing industry financed by the banking sector at interest rates that were determined by policy rather than the supply and demand of capital. These very high rates of investment are not consistent with a slower potential growth rate of GDP so there is likely to be a decline in the share of fixed investment in GDP, some rationalisation of the state owned sector and a liberalisation of capital markets that will mean higher interest rates to borrowers. Moreover, because the labour market is tight, wage growth is cutting into corporate profitability which is increasing the pressure for rationalisation. Again, possible trends associated with a shift to a lower growth model could be a rise in non-performing loans as some sectors are opened up to more competitive economic forces, a relocation of labour intensive manufacturing to other countries in Asia as Chinese wages rise, and an increase in middle income consumption as a share of GDP. It is hard not to think of China being the low cost manufacturing hub of the global economy, but the benefits of rapid growth are higher per capita incomes and a shift of resources into more value added industries. There should also be, over time, a rise in China’s real exchange rate and a relative decline in its balance of payments surplus.
• Not such a strong structural influence on global yields – during the last decade or so, China not only massively increased its share of world export markets, but also became a leading supplier of capital to the rest of the world. Its foreign exchange reserves stand at almost $3.3trn and are invested widely in developed markets. For some time there has been a fear in the bond market that Chinese reserve managers had the power to send yields shooting up should they choose to disinvest from, say, US Treasuries. Of course, this is a ridiculous idea unless China decided to repatriate those reserves into yuan, thereby undergoing a massive upward revaluation of the currency and probably destroying its export sector. While the threat of diversifying out of US Treasuries into other assets might have been used as a political weapon, the reality is that no realistic alternatives exist, given the small size or major risks associated with other bond markets. However, what could happen is that China becomes a less important marginal buyer going forward, if the current account balance starts to move lower. It is already evident that reserves have levelled out over the last year. The US is likely to struggle to (or avoid) bring down its deficit quickly in years to come, such that the supply of Treasuries relative to the marginal demand from China may shift meaningfully. Moreover, China won’t be the source of manufactured goods disinflation that it has been. Manufacturing costs are rising rapidly and, for choice, the Chinese currency will appreciate. China could actually become a source of inflation globally, through the impact on relative prices in manufactured goods and though its demand for commodities. If China’s globalisation has been a structural reason why real interest rates have been so low in the last decade or so, this factor may be less powerful going forward.
• Bonds remain supported by macro, sentiment and technical factors – These are a long term issues and in the short term focus will remain on whether growth in China has stabilised or not. If it has then the current good mood in the markets will continue. But there are a range of other things that could and probably will contribute to what another of our favourite strategists calls the “violent risk-on risk-off environment” – the “will they/won’t they” question regarding Spain’s potential request for a bailout, the ability of the new policy infrastructure in Europe to break-the link between banks and sovereigns, and the outcome to the US presidential election, are the main ones. In the bond markets we have had a very good year, with investment grade and high yield delivering double digit total returns. Our view is these assets will remain well supported by plentiful liquidity, a stabilisation of the growth environment, strong technicals and positive sentiment. The only issue is valuation, where some parts of the credit market are starting to look expensive. However, this is by no means all of the bond market and low central bank interest rates will remain a magnetic force for bond yields well into 2013.
• 25 years ago….was the stock market crash of 1987. I was a junior economist working for a financial research house that focussed on country risk and the immediate fear following the crash was that global growth would collapse, countries would default and the financial system would implode. Funny how things don’t really change. Thankfully, we have so far avoided a financial disaster that would make October 87 look like a mere blip (as it does on long term charts of the stock market now) but the underlying fundamentals in Europe remain weak and scenes of protest against austerity on the streets of European capitals again this week highlight the political risk that is embedded in the current situation. The ECB has done a good job but risks remain. There is a wonderful line in the charming movie, The Best Exotic Marigold Hotel, which goes, “Everything will be alright in the end, so if it is not alright yet, then it is not the end”. If the economic outlook is not alright, then it is not the end the bond bull market”.