July 2019 Newsletter: Global Slowdown and Negative Bonds

July 22, 2019

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The Rise of Negative Bond Yields

For the past year and a half, since the beginning of 2018, the world’s economic growth rate has been slowing.

This chart, for example, shows the global composite purchasing manager’s index and GDP growth, with three clear mini-cycles of growth acceleration and deceleration since the world emerged from recession in 2009:

Chart Source: JPMorgan and IHS Markit

Manufacturing has been in a mild contraction lately (a PMI reading below 50), while the services sector has held up over 50, and the composite between the two is currently above 50, but only barely. We’re on the downtrend of the third mini-cycle, and it’s unclear if it will change course and move back up for a fourth mini-cycle, or if this one will continue to dip into actual recession.

As global growth slows, a concerning international trend right now is that the sovereign bond yields of many developed countries are yielding negative interest rates. There is more than $13 trillion worth of negative-yielding bonds in the world now, including many long-duration bonds:

Chart Source: Bloomberg

Before 2014, there were no negative-yielding bonds. There were small amounts of them in 2014/2015, and only in 2016 and beyond has this trend become so large. During the past year it has really taken off.

Rather than getting paid interest in exchange for owning a bond, these bondholders are paying for the privilege of lending money to their governments. More specifically, rather than actually paying a negative rate, they are paying money up front in exchange for a promise of less money in the future, like buying a $100 bond for $101. The effective yield to maturity is negative.

Here are some current 10-year government bond rates around the developed world and the emerging BRIC countries:

Country	10-Year Yield	Inflation Rate	Real Yield
United States	2.05%	1.6%	0.45%
Germany	-0.32%	1.6%	-1.92%
France	-0.06%	1.2%	-1.26%
United Kingdom	0.73%	2.0%	-1.27%
Japan	-0.13%	0.7%	-0.83%
Brazil	7.31%	3.4%	3.91%
Russia	7.35%	4.7%	2.65%
India	6.36%	3.2%	3.16%
China	3.19%	2.7%	0.49%

• The United States has the highest yields in the developed world for now, even though our rates are low by historical standards.

• Yields in certain other developed areas, like Australia and Singapore, are also still in positive territory. They are basically flat/negative in inflation-adjusted terms.

• Emerging market country yields, due to their elevated risk and lower credit ratings, are always quite high and still provide positive inflation-adjusted rates of return.

• Europe and Japan are in the zero/negative range now, and deeply negative in inflation-adjusted terms.

Germany is one of the most interesting cases. Their 10-year bond offers a yield of -0.32%, while inflation there is currently 1.6%, so bondholders are currently earning -1.92% in purchasing power per year on their bonds. For those intending to hold these bonds to maturity, they are locking these low interest rates in for a decade.

Here is the four-decade declining trend of German 10-year yields:

Chart Source: Trading Economics

The German 30-year government bond, which locks interest rates in for three full decades, is yielding 0.3%. France’s 30-year is yielding 0.9%. Both of these ultra long-term bond yields are below their country’s current inflation rate, so the real purchasing power change over this three-decade period could very well be negative.

Back in 2017, Austria issued a 100-year bond for an interest rate of about 2%. Now it is down to about 1%, and they are issuing more. These bonds will mature in 2117 and 2119, respectively. Inflation in Austria is currently 1.7% per year, so the 100-year bond yield is below current inflation levels.

During the European Sovereign Debt Crisis in 2012, investors were concerned about the high sovereign debt levels of some southern European countries like Italy, especially because they are part of the Eurozone and thus can’t print their own currency, and could potentially default. Italy’s 10-year government bond yields spiked as high as 7% during that time. Now, just seven years later, Italy has a higher debt to GDP ratio than they did in 2012, their 10-year yields are down to 1.6% and the country is issuing 50-year bonds for 2.8% yields, and there is huge demand for them. Institutions can’t get yield anywhere else in Europe so they are pushing out on the risk spectrum to buy 2.8%-yielding ultra-long-term Italian debt.

Would you lock money away for a century in Austrian bonds at 1%? Or in 30-year Germany bonds at 0.3%? Or in Italy for 50 years at 2.8% when they had a sovereign debt crisis seven years ago at lower debt levels than they have today? If there is any substantial spike in inflation at any point along these long periods of time, your investment could be decimated. Even at current inflation rates, these bonds gradually reduce your purchasing power.

One thing to keep in mind is that bond yields are the inverse of bond prices. Saying bond yields are extraordinarily low is another way of saying that bond prices are extraordinarily high. Bond prices have never been this high in history. Investors are paying a very high price for the interest they receive, and in some cases, are effectively receiving negative interest.

There are several reasons for this phenomenon:

• Central banks have been expanding their money supply and using it to buy bonds in recent years, and have been discussing doing more rounds of bond-buying. This activity can push yields to extremely low levels.

• Investors can speculate that yields will go lower. As yields go down, existing bond prices go up. Investors can make big capital gains if they correctly judge the movement of bond yields within a given period of time.

• People are worried about economic slowdowns and deflation, and want to lock yields in before they go even lower.

• Many institutions, like pension funds or insurance companies, are mandated to hold investment-grade bonds as a sizable part of their portfolio. Forced buyers are relatively price-insensitive.

Here is the long-term chart for U.S. 10-Year Treasury yields (blue line) and inflation (red line):

Chart Source: St. Louis Fed

Will the United States join Europe and Japan in the coming years, with our 10-year also hitting 0% yield, or negative? It’s possible, especially if the Federal Reserve does a fourth round of quantitative easing during a recession. Quantitative easing is when the Federal Reserve (or any central bank) expands the monetary base to buy bonds or other assets to inject liquidity into the market and drive yields down.

I think that there’s a good chance, looking back at this 10 or 20 years from now, we’ll see that this period of negative-yielding bonds doesn’t end well for many investors.

My concern is that although recessions, economic slowdowns, technological improvement, and high debt levels are inherently deflationary, central bank actions to combat that deflation can be inflationary. As inflation gets to really low levels and growth remains sluggish, there are rare tools that central banks can use to expand their monetary supply and devalue their currency if they absolutely need to. That is the playbook that has happened throughout history when an economy gets to a breaking point of debt and deflation.

I wrote about this problematic trend in more detail in my recent article about bond investing.

In the shorter term, traders can potentially make a lot of money if they are right about the direction of yields. As Daniel Amerman charted, for example, the 1-year capital gains from buying a 10-year treasury bond at a starting yield of 2.5% and selling it a year later at a yield of, say, 0.50%, would be over 19%:

Chart Source: Daniel Amerman

On the other hand, if inflation picks up and the yield increases during the holding period of the bond, its purchasing power can be severely reduced. This effect is magnified for 20-year, 30-year, or 100-year bonds.

Government bonds are not “risk free” as commonly described. They are essentially risk free in nominal terms if held to maturity, but they do not guarantee that they will not lose purchasing power for their duration. Investors and institutions, especially ones intending to buy-and-hold until the bond matures, take on inflation risk, yield risk, and devaluation risk when they buy 10-year, 20-year, or longer bonds.

The Third Peak

If we look at the ratio of household net worth to disposable income in the United States, (a good measure of asset prices relative to underlying fundamentals) we see three distinctive peaks over the past two decades:

Chart Source: St. Louis Fed

The first peak in 2000 was caused by an overvaluation of stocks during the dotcom bubble, while real estate and bonds were still priced normally.

The second peak in 2007 was caused by an overvaluation of real estate leading up to the subprime mortgage crisis. Stocks were only moderately expensive, but since banks were caught up in the real estate bubble, the stock market crashed anyway. Bonds were more expensive than in the prior peak, but still had real yield. Houses were extremely expensive.

In this third peak today, neither stocks nor real estate are quite as expensive based on most metrics as they were back in 2000 and 2007 respectively, but both stocks and real estate are priced well above their historical average, and bonds are at their highest price level ever. The overall result is that the ratio between net worth and income has hit record levels.

We see similar results if we compare total U.S. household net worth to GDP. Historically, net worth (blue line) has consistently been a little less than 4x GDP (red line), but low interest rates have pushed up the valuations of all assets. We had a small peak in 2000, a bigger peak in 2007, and now we’re at the largest peak yet:

Chart Source: St. Louis Fed

This is what some investors are referring to as the “Everything Bubble”, meaning that almost all asset classes are expensive and likely to offer lower forward returns than their long-term averages.

Bubbles can deflate in various ways. They could crash, or they can simply let the air out slowly and result in poor returns for a time.

Stocks vs Bonds: A Conundrum

There are many ways to value stocks, and many of these ways can be applied to a stock market as a whole to see on average how expensive stocks are at any given time.

A common metric is the “equity risk premium”, which is a measure for how much earnings you get per stock share compared to how much interest you get for holding a government bond.

The equity risk premium is frequently calculated as the difference between the earnings yield of the S&P 500 (annual earnings per share divided by share price), and the 10-year U.S. treasury yield. Here, for example, is the S&P 500 trailing earnings yield over time:

Chart Source: multpl.com

And here again is a 10-year treasury yield chart (blue line):

Chart Source: St. Louis Fed

Putting those together, the S&P 500 earnings yield minus the 10-year U.S. treasury bond rate, the equity risk premium over time has looked like this:

In theory, the higher that is, the better deal you are getting on buying stocks vs bonds. However, astute readers can tell right away that this isn’t very useful.

The reason that the standard price-to-earnings ratio (and inversely the earnings yield) of a stock market is an unreliable valuation metric is that earnings can go down during a recession. That chart made it look like stocks were expensive compared to bonds in 2009, when in reality, the best time to buy stocks in modern history was in 2009 (when one-year earnings were briefly very low). Other valuation metrics such as price-to-book, price-to-sales, market-cap-to-GDP, price divided by next year’s expected earnings, make it clear how cheap stocks were at that time, and the forward stock returns were excellent.

We can adjust for this by using an inverse CAPE ratio instead of the simple one-year earnings yield. In other words, we take the earnings yield (this time based on the average of the past ten years of inflation-adjusted earnings rather than just one year’s worth of earnings), and find the difference between that figure and the current 10-year bond yield:

This chart, which simply shows the difference between the inverse CAPE ratio and the 10-year U.S. treasury yield, has been very reliable for determining approximate forward equity rates of return.

High points on the chart, such as the 1950’s, late 1970’s, and 2009-2015, were almost always great long-term stock-buying opportunities.

Low points on that chart were almost always bad stock-buying opportunities. For example, 1929 and the late 1960’s, were the beginning of the two worst bear markets in U.S. history. They were not good buying opportunities in stocks.

The lowest the equity risk premium ever reached was during the 1999/2000 dotcom bubble. The S&P 500 earnings yield dipped to just 3% (and the more reliable inverse CAPE version dipped to 2.5%), while 10-year treasury bonds paid you almost 7%. It was such an obvious call to switch to bonds that even Jack Bogle, the founder of Vanguard and the father of passive index investing, said he personally took some extra money out of stocks and put it into bonds. Bond returns absolutely crushed stock returns going forward, and even 20 years later are still ahead from that point.

The only time when the equity risk premium was negative on the chart and yet stocks still provided great returns was during the early 1990’s. At that time, real bond yields were relatively high, stocks were moderately priced, and the economy performed exceptionally well, so although the equity risk premium was low, both stocks and bonds went on to perform very well over the next decade, with stocks outperforming bonds.

Basically, although average stocks in the S&P 500 are relatively expensive at the current time, they still are likely to have higher long-term returns than bonds. It’s not that long-term stock returns from this level are likely to be good; it’s that long-term bond returns are likely to be very low and that stock returns are likely to be moderately low. The actual results are hard to say, and depend on the timeframe in question.

Stocks will be more volatile than bonds, and they might not outperform bonds over a given 3-year period, but it’s still rational to buy some stocks compared to putting all of one’s money in cash or bonds in my opinion. I have a blend of stocks, cash, short-term bonds, and some other defensive assets.

Stocks also have the advantage of being resilient to inflation. If we get a tail risk scenario where central banks intervene against deflation and trigger inflation, stocks would hold up better than bonds.

So What is Cheap These Days?

Low interest rates have pushed up valuations in most asset classes. If bonds are at record valuations (low/zero/negative rates), U.S. stocks are also historically expensive with likely low forward return potential (based on CAPE ratios and other valuation metrics), and real estate in prime cities is quite pricey as well, then what are investors to buy?

Quality/Value/Dividend Stocks

As I showed with the equity risk premium analysis above, I think that a variety of stocks are still reasonably priced.

Many software companies and IPO stocks are at higher valuations than I consider reasonable for their forward cash flow potential, but many stocks that exhibit a blend of quality and value are reasonable in my opinion. Stocks that are in the moderate value range, have good balance sheets, decent growth prospects, generally pay dividends, appear to be good candidates compared to bonds.

The following chart shows the Russell 1000 Value index divided by the Russell 1000 Growth index. Whenever the line is going higher, it means value is outperforming growth. Whenever the line is going lower, it means growth is outperforming value:

Chart Source: St. Louis Fed

For the past 12 years since 2007, growth stocks have outperformed value stocks, on average.

This doesn’t mean value must outperform in the future, especially because many value stocks have high debts and/or are being disrupted by new technologies (retail) or low interest rates (banks). It has been a transformational period for growth stocks as smart mobile devices have become widespread (the first iPhone came out in 2007 and now everyone has a touchscreen smartphone), online retail has taken market share from physical retail, and digital media has displaced traditional media. However, it can give us some clues on where to look.

Currently, I like a lot of stocks that exhibit a blend of value and quality that aren’t as highly demanded as some of the popular software companies at the moment.

I like stocks such as Unilever PLC (UL), Bank of Nova Scotia (BNS), Lam Research (LRCX), Lazard (LAZ), Nutrien (NTR), Lowe’s (LOW), Royal Dutch Shell (RDS.B), and Kinder Morgan (KMI). There are reasonably-priced growth stocks I like as well, including Alphabet (GOOGL), and Nvidia (NVDA).

There are other names like Rockwell Automation (ROK), Discover Financial Services (DFS), Invesco (IVZ) and Micron Technology (MU) that are more cyclical, but that I’m happy to buy on dips.

For people with higher risk tolerance, there are some retail names like Nordstrom (JWN), Macy’s (M) and Tanger (SKT) that are facing real headwinds but their stock prices seem to have crashed well below fair value, with high dividend yields. Contrarian and deep value investors may want to poke around the retail space, as some of them have fundamentals that aren’t as bad as their stock prices suggest. Caution is warranted, though.

Basically, while most stocks are not at deep bargains, many of them are still quite reasonable for long-term holders. Especially dividend growth stocks with strong balance sheets that sell rather future-proof products and services.

• Read More: Value Stocks Guide

Emerging Markets

By many metrics, emerging markets are among the cheapest they have been relative to U.S. stocks since the early 2000’s. It has been a rough decade for them.

• The iShares emerging markets ETF has a price-to-earnings ratio of 12.2 and a price-to-book ratio of 1.6.
• The iShares S&P 500 ETF, in comparison, has a price-to-earnings ratio of 21.0 and a price-to-book ratio of 3.3.

Although emerging markets have more expected growth over the long run, the S&P 500 should have a valuation premium due to its safety and diversification. However, the valuation premium has rarely been as wide as it is now, meaning that emerging markets are historically cheap relative to the S&P 500.

Historically, whenever emerging markets were this cheap, their returns over the following decade were quite good.

Source: Topdown Charts

I don’t know how emerging markets will do over the next year or two, but I have a reasonably bullish outlook on them over the next 5-10 years. On average, they have lower debts, faster growth, and lower equity valuations than the United States.

• Read more here: Emerging Markets Guide

Commodities

Many commodity prices are at historic lows relative to stocks and other assets. Here is the ratio of a major multi-commodity index to the S&P 500:

Chart Source: Doubleline referencing Incrementum

• Although gold is in a 7-year bear market from its peak, it has been one of the stronger commodities over the past two decades.

• Silver is in a deeper bear market, with a gold/silver price ratio near record historical highs. It is produced as a byproduct of other metals, so its supply/demand balance can vary significantly.

• Copper is in a bear market because Chinese economic growth rates have declined, and China has been a huge demand driver for copper. There is currently no supply/demand shortage, but most analysts estimate that at current supply rates, there will be a deficit in the 2020’s that should push up copper prices.

• Oil is historically cheap because shale technologies have allowed the United States to become a top oil producer over the past decade, which has disrupted the global supply/demand balance and weakened OPEC’s influence on oil prices.

• Most agricultural commodities continue to be in long bear markets as well.

Investing in commodity producers is difficult because commodity production is inherently a bad business model in most cases. Commodity producers don’t really have control over the price of their product, and yet they have to make immense capital expenditures to acquire mineral reserves and build mines. I expect many commodities and commodity producers to do well over the next decade from this relatively low base, but it pays to be very cautious when investing in this area.

At current prices, I prefer holding a small portion of my portfolio in precious metals for my defensive asset class of choice, because unlike bonds that have lousy long-term return potential in a low interest rate environment, precious metals historically benefit from lower interest rates. The reason for this is because during periods where you can earn a high inflation-adjusted yield on your bank account or safe bonds, it makes more sense to hold cash and bonds than gold, since gold provides no yield. However, when inflation-adjusted yields on bank accounts and bonds is low, zero, or negative, gold and other precious metals historically do a better job of preserving long-term purchasing power.

Bonds and bank accounts in Europe and Japan currently provide negative/zero real yields. In other words, there is a high probability of gradually losing purchasing power over the long term with cash and bonds. In the United States, bank accounts and safe bonds can provide over 2% interest rates, but inflation is about 1.6%, so the real yield is very low. This makes holding commodities and in particular precious metals a compelling alternative to cash for a portion of a portfolio.

• Read more here: Precious Metals Investing Guide

Portfolio Updates

I have four investment accounts, and I provide updates on my asset allocation and investment selections in each newsletter issue.

These include a primary passive/indexed retirement account, two actively-managed brokerage accounts at Fidelity and Charles Schwab, and the new account specifically for this newsletter at M1 Finance.

I use a free account at Personal Capital to easily keep track of all my accounts and monitor my net worth.

M1 Finance Newsletter Portfolio

I started this account about nine months ago with $10k of new capital, and I put an additional $1k into it before each newsletter issue, totaling $17k so far.

It’s by far my smallest account, but the goal is for the portfolio to be accessible and to show newsletter readers my best representation of where I think value is in the market.

I chose M1 Finance because their platform is commission-free and allows for a great combo of ETF and individual stock selection with automatic and/or manual rebalancing. It makes for a great model portfolio with high flexibility, and it’s the investment platform I recommend to most people. (See my disclosure policy here regarding my affiliation with M1.)

After adding $1,000 in fresh capital in July, here’s the portfolio today:

Here’s the more detailed breakdown of the holdings:

Changes since previous issue:

• I added a position in Nordstrom in the dividend stock pie.
• I added a position in Nvidia in the growth stock pie.
• I added a position in Skyworks Solutions in the growth stock pie.
• I added a position in Pan American Silver in the commodities pie.
• I added a position in the iShares Malaysia ETF in the international pie.
• I reduced some other allocations slightly to make room for these.

If you want to see some simpler ETF-only portfolio ideas, see my article on 3 simple diversified portfolios.

Primary Retirement Portfolio

This portfolio is my largest and least active. It purely consists of index funds that automatically rebalance themselves regularly, and I rarely make changes.

Here’s the allocation today:

From 2010 to 2016, this account was aggressively positioned with 90% in equities and enjoyed the long bull market.

Starting in 2017 in order to preserve capital I dialed my equity allocation down to 60% (40% domestic, 20% foreign). This was due to higher stock valuations and being later in the market cycle more generally. If and when the U.S. economy encounters a recession and significant bear market, I would likely increase equity allocations to upwards of 90% once again.

Related Guide: Tactical Asset Allocation

One reason this is so conservative is that my active portfolios below are more concentrated and aggressive, so I consider them together when determining how to allocate assets.

This is an example of a portfolio strategy that takes a rather hands-off approach but that still makes a tactical adjustment every few years based on market conditions. This employer-based retirement account is limited to a very small number of funds to invest in, so my flexibility is limited compared to my other accounts.

Active Portfolios

My accounts at Fidelity and Schwab are mainly for individual stock selection, single-country ETFs, and selling options:

Changes since previous issue:

• I bought shares of Sprott Inc (SII/SPOXF – alternative asset manager).
• I sold September 2019 cash-secured puts at a strike price of $10 on Freeport-McMoRan (FCX- copper producer).

___

My next newsletter issue is planned for early September, six weeks from now. These are pretty interesting times, and we’ll see if the global slowdown continues or starts to reverse to the upside.

In the meantime, I’ll personally remain diversified, with an emphasis on dollar-cost averaging into quality/value/yield stocks for solid risk-adjusted returns, a portion of tech exposure for extra growth, emerging markets exposure for the long term, and some cash and precious metals for defense and potential future buying opportunities.

Best regards,