Focus on Fixed Income
In the last Live Market Update for our clients, we talked about the importance of the bond market in predicting economic conditions. For all the talk about how the stock market is a perfect aggregation of information across all market participants (i.e. people), it actually does a pretty crummy job of predicting future economic troubles. In fact, equities lag behind economic decline in most cases. For instance, the Great Recession was well under way by the time the stock market corrected and collapsed nearly a year later. Keep in mind that it takes months to a year to collect enough data to determine the actual start of an economic decline.
While academics and theorists claim the market is “efficient,” the opposite is often true. Equities appear to move almost entirely on expectations formed from the last 30 days of market experience, with news “shocks” randomly bumping it off that trajectory. This can be seen today in the fear gauge, or the VIX. As markets climb the fear gauge creeps lower and lower to reach historical levels when the markets are doing fine. Yet as soon as something comes along to disrupt expectations, such as the yuan devaluation last August, the VIX soars to levels indicative of a massive economic collapse—reactively, not proactively.
That leads me to a discussion of bonds. Also called fixed income, this market is many times larger than the stock market and encompasses a wide range of instruments from mortgages to auto loans. It is also a space retail investors have eschewed for the past five years. Back in 1994 when I interned on the floor of the New York Stock Exchange, I already noticed an interesting contrast between people working in equity markets versus those working in fixed income. Those working in the equity markets were typically guys of moderate education with strong sports backgrounds. Those in fixed income were a more diverse bunch of quants, often with advanced degrees in physics, mathematics and economics.
While the nature of equity trading has evolved since that time, it is still true that the fixed income arena requires a more nuanced understanding of mathematics and economics. For reasons that likely are related to these factors, the bond market is a remarkably good indicator of future conditions. Figures 1 and 2 show this in both the Dot-Com burst and the Great Recession. In both cases, the difference in yield between 2-year treasury notes and 30-year treasury bonds moved to zero. The positive yield difference in these two instruments is usually a reflection of expectations of future inflation. In both instances, this bond market metric correctly predicted that future inflation disappear as the economy went into a severe contraction.
While nothing is perfect in any market, the analysis of the bond market is typically a good indicator of what is to come, at least at its extremes. Today we sit at an odd point with those indicators. The 10-year U.S. treasury rate is at its lowest point ever (see Figure 3). Comparative rates in Germany, Switzerland and Japan are all negative—meaning investors will get less than their principal back when they buy a 10-year bond from those governments. And looking here at the U.S. yield curve (Figures 1-2), the 30 minus 2-year rate is declining slowly but steadily.
So while neither of these indicators is a clear signal of trouble ahead, the trends undermine the prospect of strong economic conditions inferred by the equity market rally. Going forward, these conditions start to make a strong case for depressed equity returns in the next few years with modest gains in the bond market. In other words, play for a relatively safe investment strategy with less reliance on equities coupled with modest expectations for returns in the next few years.
Regards,
David B. Matias
Managing Principal
