The lack of value in fixed income is rendering the asset class useless to investors, argues James Montier, a strategist at GMO.
He starts off with a pair of charts that show the fund house’s seven-year outlook for core asset classes, snapshots taken in 2007 and today.
In 2007, GMO was sceptical about the ability of equities to meet historic rates of return, but found improving value in a variety of fixed-income segments:
In its current seven-year outlook, the firm expects equities to continue to perform well below historic rates of return (except for emerging-market stocks, reflecting GMO’s traditional counter-cyclical approach):
But the fund manager's expectations for fixed income are devastating, predicting losses in sovereign bonds except for emerging markets. It also expects positive gains in US credit (not shown), but Montier warns that reaching for yield is being done at uneconomic valuations.
Montier suggests that central bank quantitative easing is hampering the prospect of a reversion to means – i.e. that long-run rates are no longer determined by markets, but by central banks.
“Treasuries offer low returns under most scenarios,” Montier writes in a new report, The Purgatory of Low Returns. If the US Federal Reserve steps away from the markets and begins to normalise monetary policy, investors in bonds get a negative return. If it continues its current policy, investors in bonds get a low return.
“You are pretty much doomed either way,” he says, arguing the only scenario that is good for bondholders is deflation, and that there is no upside to owning Treasuries.
“I am well aware of the dangers of proclaiming the death of an asset class," adds Montier. "Barring the deflation outcome, we could finally be witnessing what [British economist John] Keynes described as the euthanasia of the rentier."
He also doubts that Treasuries will provide any diversification benefit to an equities portfolio, because the correlations are often high, particularly at low yields. “If you own bonds as insurance, you must ask yourself how much you are paying for that insurance,” he says.
Given the inability of investors to generate anything beyond low returns, Montier says they face four choices: ditch diversification to concentrate on the highest-returning assets; seek alternative investments (bearing in mind that in 2008, hedge funds and private equity tended to correlate to equities); use leverage; or keep a higher allocation to cash and bide your time.
Unfortunately that is a luxury that many liability-driven investors do not have.