Sunday, 8 August 2010

A Bonded future?

Quick rallies make me a little more skeptical than usual. The bond markets seem to tickle the skeptic in me. In times of doubt, I turn to history for a new perspective through which to view the present moment. As I browsed through the past, I chanced upon this article on the Great Bond Massacre of 1994. As with almost all instances, the 1994 bond market episode is instructive as much for the parallels with the present moment as for the uniqueness. Back then, as today, bond yields were at historic lows and inflation was muted. Wages were subdued and companies were struggling to raise prices. At the same time, idiosyncrasies exist, making the comparison an interesting and instructive exercise.

In 1994, euphoria ran high and the big spread between short and long rates saw speculators loading in on the carry trade (borrow short, invest long). The Fed kept rates low as the Clint
on administration contemplated ways of slashing the deficit and Mr. Greenspan worried about inflation. Then Mexico sneezed, setting off a bout of contagion that quickly spread across the globe. US responded to a strengthening economy by bumping up short rates. Bulk selling of bonds began, pushing rates up, causing a death spiral for leveraged, long-duration longs. And as with the current crisis, hedge funds were promptly blamed. Some things are timeless indeed...

Cut to the present. Bond issuances have picked up strongly. July was the strongest month on record for global high-yield issuances ($24 bn). Companies sold $90 bn of U.S. corporate bonds in July, the most since 1999. Average yields on the securities fell to 5.01% on July 31, the lowest since April 2004. Bonds have outperformed equities YTD and Purchasing Manager's Indices have beaten expectations in
several regions (barring China). The consensus seems to discount a low interest rate environment in the near-term and deflation seems to be at the top of the agenda. A sustained uptick on the indices could see GDP growth expectations headed in a direction that would make the deflation argument less forceful as time passes by. Could a surprise rate hike see a repeat of 1994?

Here's a quick capture of economic data from 1994 compared to the present.


Budget deficit was $200 bn back then. It is $1,500 bn today. Debt-to-GDP ratios have jumped sharply over the years and average GDP growth rates were vastly different between then and now. Increasing indebtedness and an unprecedented economic slowdown have led to interest rates hovering at near-zero today. US consumers are emerging from a period of historically low savings rates. As they grapple with a sluggish economy and a period of personal balance sheet retrenchment, the government's stimulus/quantitative easing (QE) programs are likely to have only a limited effect in jump-starting consumer spending. The Fed wants consumers to spend at precisely the moment when they seem most ill-equipped to do so! Low rates notwithstanding, I think consumer spending will take longer to recover than in previous instances (1973/75 recession a good example). The QE could see inflation rearing its head in the future but the probability of this scenario playing out in 2011 seems remote.

This would imply two things; (1) interest rates will continue to be low for a longer period than in previous instances and, (2) there is a risk of the US getting stuck in a Japan-like deflation spiral. I believe the consensus is focusing on these two broad factors, explaining the rally in bonds YTD relative to equities.

However, a couple of things force me to consider the alternative hypothesis.

(1) The encouraging corporate profits as a % of GDP number compared to 1994. Since bottoming in 4Q2008 (~8%) , this metric has been on an uptrend.

(2) The room for maneuver of interest rates. Rates are at near-zero bound and the low rate/deflation hypotheses largely seem discounted in prices.

When the weigh balance of investor preferences tilts to one side, it is always useful to consider the other side of the weighing scale. Consensus seems to be firmly behind bonds currently. From the above exposition, and
YTD outperformance of bonds over equities, I think risk-reward favours equities relative to bonds in the near-term. Bonds may not pop as in 1994, but the risks of a GDP spike increases the risk of a rate hike, which would impact bonds more negatively compared to equities.

Saturday, 7 August 2010

Conjectures and reality

I have always loved writing. Investing, it turns out, provides ample opportunities to pander to the writer's urge in me. Apart from serving as a repository of my misses (which have been way more instructive than the hits), the blog has been a storehouse of investment conjectures over time.
I strongly believe the best gauge of one's guessing ability is to periodically note down investment conjectures and test them against reality. This has helped me get better at guessing over time. One can never get everything right all the time (I have had the good fortune of numerous humbling experiences), but net-net if one's guessing right, I think things will be alright over the long run.
Below are excerpts from my writings in the past. A check of predictions versus subsequent performance.

The following was written on July 31, 2007 when the S&P 500 index was ~1,500.

Credit spreads have widened sharply over the past few months after bottoming out at historic lows, but the equity markets, as usual, haven’t begun their reaction....On most occasions, equity markets have lagged developments in Credit Spreads and this time seems no different. If history repeats itself, it wouldn’t surprise me if the equity markets corrected in the short-to-medium term.
S&P topped couple weeks later and broke sharply soon after...down 27% through today.

And this is from earlier this year (Mar 23, 2010).


In sum, the divergence in market values from underlying GDP performance is unlikely to be sustained in the future, in the absence of strong catalysts. Positing a scenario of a high inflation future coupled with deleveraging and sluggish growth, gold (and other precious metals) as an asset class appear attractive relative to equities.
S&P fell 13% to its trough; has recovered since, down 5% through today. Gold is up 10%...

This exercise has helped me learn a great deal about my investing style, my comfort zone and my weaknesses. I believe the world is inter-linked, which means opportunities exist across geographies and asset classes. The natural skeptic in me feels a wee bit more comfortable scouting around for things that are ripe for corrections. Someone, somewhere, is going bust all the time! And as life is a zero-sum game, this implies there is a beneficiary lurking somewhere...


While the hits are encouraging, the markets ensure there are enough misses to prevent the unwanted growth of a big head.
Capacity for objectivity is inversely related to head size.
The pleasure - quoting Richard Feynman - lies in finding things out!