Five years ago, everyone was of the opinion the bond market was in its seventh‑inning stretch. Today, the same message is being repeated. While I agree that bond markets have been frozen at the seventh‑inning, I would also point out that we have been there for some time.
The debt clock, showing the four stages of a credit cycle – downturn, credit repair, recovery and expansion (late cycle) – seems to be stuck at the “expansion/late cycle” phase. Although the clock in the US is slowly beginning to move, Europe’s is broken. Overall, we are in the midst of a very slow moving cycle, which may turn out to be the longest in recent history.
And it is not just the credit cycle that appears to have become stuck. The same is true of interest rates, economic growth, inflation and default cycles.
The recent period of recovery has naturally led to reflation theories. However, while there is evidence of an uptick in headline inflation, core inflation (excluding volatile items such as food and energy) remains subdued. There is also evidence that a mild slowdown in economic activity in China and the US will likely emerge around summer.
No structural regime change
The uptick in inflation and economic activity has occurred in response to a number of factors, including a loosening of monetary policy in China a year earlier, sparking a rally in commodities that helped produce better economic data in the developed world since the middle of last summer.
Thus, markets began to move from last June and trading strategies switched to those favouring equities over bonds. Later, the view that growth and inflation are likely to rise based on a Donald Trump US presidency bumped sentiment higher but the “Trump effect” was just fortunate timing.
All in all, this does not indicate a regime change, in our view. It is essential not to confuse the China‑induced cyclical upturn with the longer-term structural issues that persist in the global economy. We have long talked about a number of structural forces keeping growth and (core) inflation low. Among those are adverse demographic trends, lack of productivity, disruptive technology, digitalisation, a global savings glut and behavioural changes.
Beyond sphere of influence
The longer-term structural forces continue to challenge monetary policy in the developed world, which has been kept loose in recent years to encourage economic growth. But how much longer can it be maintained?
Central banks’ ability to adjust economic growth in the future through interest rates seems diminished. A key indicator is r* (the natural or equilibrium rate of interest when real gross domestic product is growing at its trend rate and inflation is stable).
Studies have shown that over the past 25 years there has been a huge decline in r* across North America, the UK and Europe, reaching historically low levels in the recent past. The underlying cause is the structural factors mentioned earlier, which appear poised to stay.
As such, it looks like r* will remain at low levels in the future, by extension implying lower growth and inflation. This is important, as, while central banks can set interest rates to influence the economy, r* is a function of the economy and beyond their sphere of influence.
So even a few rate hikes by the US Federal Reserve would not heavily influence economic activity. In fact, the latest hike led to lower government bond yields (higher prices) as long maturity bonds rallied, doubting the reflation theory. This is another example of equity markets following soft economic data such as surveys and sentiment indicators, while the bond markets concentrate on the hard economic facts.
And while the Fed seems poised to increase rates, can it really decouple its monetary policy stance from the rest of the world? Sweden (2010) and Europe (2011) tried but had to reverse course soon after.
Another important benchmark for central banks in gauging the appropriate stance of monetary policy is the non‑accelerating inflation rate of unemployment. This is the unemployment rate consistent with a steady level of inflation in the near future. In simple terms, inflation will tend to rise if the unemployment rate falls below Nairu (due to rising wage pressures) and vice versa.
Interestingly, the Bank of England has lowered its view on where Nairu is, since wage inflation is not as strong as expected for the current level of unemployment. With limited evidence of wage inflation in the US, could they follow suit?
Dull carry or over-complexity?
Given historically low yields in fixed income markets, many have sought alternative investments such as over‑leveraged structured products or private placements in a bid to find extra returns. In addition, with the stockmarket’s current upbeat assessment of growth and inflation, everyone is short duration and underweight gilts.
One should remain wary of illiquid alternatives as they have inherently more risk. Carry – the coupon income – may sound rather dull but it is the most sensible route to seeking long‑term returns in an uncertain world. Large‑cap, non‑cyclical businesses that have a reason to exist in the economy will serve well.
The bond markets’ seventh‑inning stretch could last a long time in the low growth, low inflation world we live in. Let carry be your friend.
John Pattullo is co-head of strategic fixed income at Henderson Global Investors