International Equities

Worldwide woes and debt

In a number of countries, long-term government bond yields fell into negative territory. Add in quantitative easing and you have a recipe for tiny yields.
December 2019

One of the most fascinating moves in recent years has been the global tumble in long-term government bond yields to never-before-seen levels. In a number of countries, they fell into negative territory. Now, you will argue that this reflects the slow-growth malaise affecting much of the world, and we wouldn’t disagree, but then add in the unique piece of monetary engineering called quantitative easing and you have a perfect recipe for tiny or non-existent yields.

But what has happened in the last couple of months? Yields have actually perked up (a bit)! Here are some examples (all 10-year yields): In the U.S. the trough was 1.458% on September 4. The yield is now 1.79% (having reached 1.937% on November 8). In the UK the trough of 0.324% occurred on October 8. The yield is now 0.673%. In Germany 10-year yields turned negative in March this year and fell to -0.752% on August 28. The yield is now -0.363%. In Japan the trough was -0.287 on August 29 and the yield now is -0.089%. In Canada the yield fell to a low of 1.09% on August 15. The yield is now 1.46%. In Australia the low-point was 0.875% on August 29. The yield is now 1.0%.1

It seems, therefore, that around August/September attitudes changed and yields reversed their seemingly inexorable slide. This does not appear to have been due to any marked uplift in overall economic sentiment as international forecasting bodies and others were still very much on the gloomy side. It does seem, however, to coincide with slightly more optimism in relation to the trade/tariff argument between China and the U.S. This ebbs and flows according to Presidential Tweets and at the time of writing there is no more clarification that can be attached to any “resolution” but assuming one is to occur each day brings us that little bit closer.

It could also be argued that yields simply fell to unjustifiably low levels. Again, we wouldn’t disagree. What it does mean is that any discernible uptick in global or country-specific inflation allied with a small increase in confidence and growth expectations will create a degree of havoc in the bond market. Long-bond yields are extremely vulnerable to sentiment shifts and capital losses lie in wait for unwary holders.

In the interests of fairness, we should point out that quantitative easing remains at the forefront of the minds of many central bankers. The U.S. Federal Reserve has ceased balance sheet shrinkage and recommenced expansion; the European Central Bank is doing the same while the Bank of Japan (BOJ) has never stopped buying domestic government bonds (currently at a rate of around 80 trillion yen a month). The BOJ already owns half of all outstanding issuance so perhaps it plans to eventually take all of the bonds on issue. The Bank commenced buying bonds in earnest in 2012 when it owned less than 10% of issuance. How times have changed. Even in Australia the Governor of the Reserve Bank has been heard muttering about the potential for quantitative easing.

So, there is the investment dilemma. The long-bond market lies somewhere between the potential for capital-loss mayhem and central banks gobbling up large quantities with no regard for the price they pay — in fact, their avowed intention is to pay higher and higher prices as they deliberately push down yields. And for what purpose? Now that’s the question we have never been able to satisfactorily answer without offending central bankers everywhere.

Global elections making headlines

In the UK a general election is looming on December 12 with Boris Johnson leading the polls by a reasonable margin. There can be many a slip in the last two weeks of electioneering and given the poisonous nature of the debate we will take our familiar coward’s approach and make no prediction. Johnson remains determined to leave the EU on January 31 and then conclude the “transition” period by December 31, 2020. Jeremy Corbyn, his far-left Labour rival, refuses to say whether he is in favor of or against leaving the EU. Apparently, he prefers another referendum. There’s decisiveness for you.

Spain held a general election on November 10 (the fourth in four years and second this year) but a fragmented result left no clear route to viable government in sight. If there was any winner — although “winner” is too strong a term — it was the far-right Vox party which gained seats at the expense of the Socialists. Nevertheless, the Socialists are endeavoring to build a coalition with left-wing party Podemos but remain short of a parliamentary majority. But now Esquerra Republicana de Catalunya (ERC), the biggest separatist party in Spain’s Catalonia region, have jumped into the mix with an offer to support a new Spanish government in return for talks on independence. However, even their support will not yield a parliamentary majority. In addition, the Socialists have refused to countenance Catalonia’s independence. We are left, therefore, with a typical (for Spain) political imbroglio. At the time of writing there is no clarity on just where this is heading.

Hong Kong held local government elections on November 24, which resulted in a landslide victory for pro-democracy candidates. This sent a clear message to Beijing, but it is unlikely much will change as Beijing still pulls the important strings. The vote was taken amid several days of calm which contrasted sharply with the months of increasingly violent street protests. Inbound tourism and retail trade have dived and Hong Kong is now in recession. It is said that a number of international firms are reviewing the need to have a base in the Territory. Singapore is likely to be one of the winners.

Hong Kong and China are scheduled for full integration in 2047, by which time it had been expected the “two systems” would be almost indistinguishable. But as time has worn on since the British handover in 1997 this seems to be little short of a pipe-dream. China has become more authoritarian under Xi Jinping while Hong Kong is seeking greater independence with full-blooded democracy. Obviously the two are incompatible. We have no insight as to where this is headed but fear that excessive provocation of China will result in an unfortunate response.

Staggering amounts of student loan debt

Moving away from politics, we note that student loan debt has now topped US$1.6 trillion in the U.S. (US$1.64 trillion as at September 20192). This debt is second only to mortgage debt in the U.S.; 37% greater than outstanding motor vehicle debt and 57% more than credit card debt (as of September). Student loans surpassed the volume of motor vehicle debt in the third quarter of 2009. Since the beginning of 2006 (earliest data) the average annual compound growth rate has been a meaty 9.3%. Over the same period motor vehicle loans have grown at a more pedestrian 3.1% annualized.

There are around 44 million borrowers, suggesting that the average outstanding loan is approximately $US37,000. It is estimated that one in four American adults is paying off student loans. The Federal Reserve reports that 54% of young adults who went to college took on some debt and that in 2018 two in ten who still owed money were behind in their payments.

Our concern is the staggering size of this debt and its rapid growth rate. If it maintains a similar rate of growth it will pass the US$2 trillion mark within six years. For reference purposes, U.S. annual GDP currently runs around US$21 trillion. The risk is that an economic downturn and/or an increase in interest rates will substantially increase loan defaults and potentially destabilize many lending institutions while adding to the already burdensome Federal Government debt load. At some point we expect some degree of debt forgiveness will be required.

It seems it is impossible to undertake any form of economic analysis without returning to the debt theme. It appears that the “solution” to any of the world’s woes is to pile on more and more debt. Relative to GDP global debt is now substantially higher than at the time of the global financial crisis. QE and other central bank initiatives have helped make the debt more affordable, but it doesn’t make it go away. The vast and growing quantity of outstanding debt is troubling in a world that has a steadily falling trend rate of growth (less than half that of 60 years ago). Leverage can be wonderful in a fast-growing environment but quite the opposite when growth fades.

Market report

Stock markets have invested heavily in the anticipation of ongoing QE as prices have continued to rise. Capital investment, productivity growth, trade, demographic change, corporate profitability and other fundamentals are ignored as the financial markets bathe in the shower of never-ending central bank largesse. In the year-to-date (to end-November) we have seen the following stock market increases (MSCI local currency price indices): Ireland: 34.1%; Netherlands: 28.3%; Switzerland: 25.7%; USA: 25.6%; Italy: 24.2%; France: 23.9%; Sweden: 21.1%; Australia: 20.3%; Germany: 19.8%; Canada: 18.3%; Japan: 14.6%; Spain: 8.9%; UK: 8.0%; Singapore: 7.2%; Norway: 6.2%; Hong Kong: 2.9%.

Oh yes, how the markets enjoy it when the central banks “print” with abandon. Pity that the “real” economy is left far behind with its participants wondering just what it is about dismal growth that can produce such effervescent stock market behavior. We join them in their wonder.

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¹ Source: Datastream – yields to end-November
² Source: Federal Reserve

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