There is historical precedent to suggest the key to good portfolio performance over the next 20 to 40 years will be avoiding bonds, although value can still be found in fixed income, a forum heard last week.
Peter Elston, head of Asia-Pacific strategy and asset allocation at Aberdeen Asset Management, drew parallels between the developed market monetary policy of today and the Great Depression of the 1930s.
Speaking on a panel debate entitled “The great rotation: fact or fiction” at the Borrowers and Investors Forum, Southeast Asia*, he noted the Federal Reserve had expanded its balance sheet amid the deflationary shock of the 1930s from 4-5% of GDP up to 15% in the 1940s.
The past few years had seen an even greater expansion by the Fed, from 4-5% of GDP to 20%. Elston pointed out that the average rate of bond returns in the US from 1940 to 1980 was -2% per annum, compared with about +5% in real terms for US equities.
“We sit here wondering about what the short-term holds, whether the 10-year [US treasury] yield is going to go back to 3% or towards the low of 1.6%, when really we should be spending time thinking about the big picture, that we are very likely to see a 20-40 year period of very poor returns from bonds,” he told the audience.
He argued there will be 20-30 years where equities perform functionally well. But he agreed that rotation out of fixed income was up to three years away and would be defined by inflation picking up. “I suspect that although equities are probably the place to be, they will react very negatively to the tightening in monetary policy in response to rising inflation, whenever that is.”
Still, Ramin Toloui, global head of emerging markets portfolio management at Pimco, said investors needed to anchor asset allocation views within a larger macroeconomic framework.
“One reason why the 50 years following the Great Depression produced poor returns for bonds was that period ended with double-digit inflation in developed countries,” he said.
He noted that macroeconomic fundamentals globally were fragile, meaning that even with low rates the global economy is still finding it difficult to generate growth – one reason why rates would likely remain low for some time.
He also warned the audience against thinking about bonds as a monolith, reminding them there are many types with different return objectives.
Freida Tay, vice-president and fixed income product specialist at Fullerton Fund Management, said she had seen some rotation out of US treasuries into corporate bonds and equities, but this was not happening in Asia.
“Now the Fed has delayed tapering, we have seen investors relooking at macro fundamentals and going back into the carry trade on the fixed income side,” she said. “We are seeing buyers coming back into this market for the short term, until we revisit the tapering theme again.”
Investors have not been moving out of bonds into equities, but from money-market funds, observed Philippe Jauer, CIO for global fixed income and currency (Asia) at Amundi.
The rotation he has seen is within fixed income, from AAA securities into AA, single A, mortgage-backed securities and credit. He added that equities had already become quite expensive.
“We will encourage investors to move to equities, but not from fixed income. We think in fixed income there is still good potential in global aggregate bonds and mortgage-backed securities,” he argued.
Elston suggested that tapering would likely drive investors out of bonds. “Without central banks, who is there to buy bonds? The demand simply dries up,” he said.
Toloui noted that central bank policy was being driven by the strength of the real economy. That led him to conclude that the greatest chance of a rotation providing a sell-off in bonds lay in stronger economic indicators.
That prompted Elston to question whether the global economy would achieve healthy growth before it experienced uncomfortably high inflation. He raised the risk that growth deteriorates because the quantum of debt is that much higher than it was.
He added that income and wealth inequality had also increased, which he described as a handbrake to growth. “My concern is that what we get first is inflation, which would put central banks in a really tight spot as to know how to respond.”
From an equities perspective, Elston suggested the weakness in developed markets had exposed floors in the emerging markets story. “Perhaps it is not the miracle that some people said it was.”
He said investors should focus on countries that had made an effort to wean themselves off dependency on the west. He named China, although conceded the country faces other issues.
Tay argued that emerging markets were now fundamentally better positioned than they had been in May, prior to the big sell-off. She forecast there would not be such a sell-off when the Fed finally does start tapering.
Asked whether quantitative easing had been good or bad for emerging markets, Toloui questioned what the alternative might have been. Without QE, he said, the world would have looked like a place with dramatically less growth both in developed and emerging markets.
“I think it would be hard to advance the case that EM countries are worse off because of quantitative easing than they would have been in the alternative, of central bank policies that would have been much more restrictive in a period where aggregate demand was collapsing.”
In terms of its economic recovery, Elston said Europe was a year-and-a-half behind the US. “But I suspect in an environment where you are now starting to see an improvement in the economy, you will see valuations rise in Europe, which bodes well for equity returns,” he noted.
On a question about Japan, Toloui suggested Abenomics was the correct policy to break a 20-year deflation cycle, although he expressed doubts over whether it would succeed, saying the best the country could hope for was 0.5-1% annual GDP growth for the next decade.
Expressing similar skepticism, Elston said his worry about Japan was that Abenomics was trying to reawaken long-dormant animal spirits. “It is very hard to get Japanese to want to live beyond their means because it is not in their culture, and on top of that you have the demographic issues.”
Tay observed that small businesses in Japan were more optimistic now and that Japanese corporates were doing better on account of yen weakness and had been investing profits into Asia, supporting the Asian bond market.
When it was suggested that a strong stock market and currency-led earnings growth was not sustainable, the panel agreed that if Abenomics failed, the Bank of Japan would simply buy more bonds.
“In Japan you have lots of investors who are ready to buy bonds even when there is a negative yield,” said Jauer. “So I do not see any big sell-off [of bonds] in Japan. Whatever happens, whether Abenomics works or not, Japanese corporate bond yields will stay where they are.”
*The Borrowers and Investors Forum, Southeast Asia took place in Singapore on October 30-31 and was hosted by AsianInvestor with sister titles FinanceAsia and The Corporate Treasurer.