The End Of An Era For Bonds?

The toughest questions in investment are not those that challenge specific views, but those that challenge deep-seated assumptions. Markets exist to accommodate a range of participants with divergent views or economic interests, so it is hardly a surprise that almost any position can be justified somehow. Those who judge the position right are rewarded, while those who do not are penalised.

But that is not how the most grievous or most costly mistakes are made. Those arise when it is investors’ entire belief systems that turn out to be misplaced. LTCM is a good case in point. Clever to a man, the principals lost their business because their faith in historical relationships that had worked so well for many years turned out in practice to break down during a period of extreme market stress.

The same, on an even bigger scale, goes for central bankers who bought in, naively, to Alan Greenspan’s convenient view that bubbles in financial markets could not be identified in advance and even if they could, would prove more costly to pre-empt than to clear up after they had burst. As he confessed to Congress in October 2008, bankers’ behaviour during the crisis had revealed “a flaw in the model ... that defines how the world works”. The cost to the world of the chairman of the Federal Reserve’s faulty assumption now runs into billions.

Are we now approaching the point with Government bonds where the assumptions that have carried this once derided instrument triumphantly through three decades of consistently good returns need to be discarded? If we are not there already, we are surely not that far away. A recent report by Andrew Smithers posed the question bluntly: “ Bonds – Government and Corporate, Nominal and Real – Why Should Anyone Hold Them?”

His argument is that at current levels Government bonds are “seriously overpriced” and therefore high risk. Returns are likely to be negative in the short term as the twin props of quantitative easing and bank window-dressing are withdrawn. Yields on inflation-linked bonds meanwhile have been driven so low by investors seeking insurance against a resurgence of inflation that, in his view, they are set to do badly whether or not inflation picks up.

Dimson, Marsh and Staunton are just as blunt in their latest Global Investment Returns Yearbook. They note that in defiance of financial theory, over the 40 years to the end of 2008 government bonds outperformed equities. Their world bond index produced an annualised real return of 4.89% between 1969 and 2008, compared with an annualised real return of 4.02% for equities. The long run real historical return from government bonds since 1900, in contrast, a period that incorporates the full gamut of human experience, including two world wars, has been just 1.0% per annum.

It is true that the anomaly of bonds outperforming equities over long periods has reversed after last year’s equity market revival, but it remains the case, the professors note, that “in an apparent violation of the law of risk and return” (than which nothing of course is more offensive to the academic mind), bonds have “produced equity-like performance, with annualised returns just a little below those on stocks, yet at much lower volatility”. Extrapolating these high returns in the future would, they conclude, “be fantasy”.

They are right about that. With 10-year yields at 3.8% in the United States and 4.0% in the UK, to project a 4.0% annualised real rate of return from Government bonds at these levels only makes sense if the world is heading for outright deflation, a fast receding possibility. Even if that were to happen, the boost to bond returns would at best be a transitory one.

In fact, from a valuation perspective it is hard to construct a plausible world economic scenario which would validate buying Government bonds today other than as a short term tactic. It is true that bonds were one of the few asset classes to display diversification value during the global financial crisis. Diversification remains the other prop, besides disinflation, on which investors’ faith in Government bonds rests.

But even this, an article of faith for entire generations of investors, is open to challenge. For Mr Smithers, the argument cuts little ice. As an instrument of diversification, cash shapes up at least as well as bonds, notwithstanding the current miserly returns on short term deposits. The huge supply overhang that is implicit in the ballooning fiscal deficits in the US, Europe and the UK meanwhile seems sure to drive yields higher. When is a only matter of time and degree.

It is not that investors who buy bonds today cannot experience one last hurrah before the 30-year cycle turns for good. There will always be opportunities to play the yield curve (now much steeper than its historical average) for profit. The message is rather that the returns of the last 30 years on which many market participants’ investment philosophy is based cannot and will not be repeated over the next 30, with all the implications that must flow from that statement.

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Andrew Smithers: Equities are Good Value!

Those of us who have been following the work of the independent market analyst Andrew Smithers for many years (and my experience goes back more than a decade) never thought we might live to see this day. But here it is - an unambiguous statement that the world's equity markets may now be the right side of fair value. This is the first time such a view has emerged from Andrew's one-man think tank since I cannot remember when, although he still qualifies it by saying he thinks the likely trend in 2009 is still down (value in stock markets being no guide to short term price movements).


The great thing about all Andrew's work is that while he has firm opinions, he has no obvious axe or vested interest to grind. Having made enough money form his years in fund management at Mercury Asset Management (in its glory days), his consultancy work today is driven as much by intellectual curiosity as by the tiresome business of giving fee-paying clients what they want to hear.


Here is an extract from his latest report, which assesses how markets stand today on the basis of what he likes to call "hindisght value", the methodology he and the Cambridge economist Stephen Wright in their pioneering book Valuing Wall Street, published just as the Internet bubble was peaking.

• We have just published a report on world market values.1 We conclude: (i) that the world market in aggregate, at the end of January, was around 38% below fair value, (ii) that the US is relatively expensive, being around fair value and (iii) that Japan is the cheapest market.

• While value is of little use in forecasting short-term market movements, our conclusions are encouraging, because in bad times, and these are bad times, markets usually become decidedly cheap.

• We remain bearish about the outlook for equities for 2009, mainly because we see the demand for shares by companies falling and their supply rising as both financial and non-financial companies change from buying shares to issuing them.

• Government bonds are expensive, though likely to remain so for a while as the world economy continues to weaken. But the short-term outlook for corporate bonds seems quite good. Their yields are determined by three main factors: (i) Government bond yields, which we expect to be flat short-term and to rise in the medium-term, (ii) the compensation for buying illiquid assets, which we expect to fall as governments and central banks push liquidity into markets and (iii) default risks, including downgrades and recovery rates, which are unknown but, we fear, still underestimated in many instances. We are optimistic that the good point (ii) will dominate over the next few months

• The refinancing of the banks, which is a necessary condition for economic recovery, is meeting opposition from voters, who think it gives unfair help to bankers and from bankers, who strive to avoid asset write-offs.

• Fiscal stimulus is another necessary condition for economic recovery, and this is meeting opposition from various sources, including those who reject or don’t understand Keynes’s theories. These groups tend to think that fiscal deficits increase total debt, rather than shift it from the private to the public sector. We expect both banks and fiscal problems to be overcome in time, but in neither case, on a worldwide basis, are sufficient steps likely to be taken quickly.

My only comment on this is that a big bounce in the stock market during 2009 is not incompatible with this view. Smithers' research centres on the long term relationship between value and price, which can be empirically assessed, rather than on short term market dynamics, which by and large can not.

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