The recent sell off … Over the last month, after the US Federal Reserve (the Fed) signaled it might curb – and progressively end – its bond-buying program, the markets slumped. Under the threat of reduced central bank stimulus and higher interest rates, all asset classes co-moved, downwards. Bonds were most affected: June was the first month in two years that ended with net outflows from bond-funds. More than USD 60 billion were withdrawn, a record exit – almost 50 percent larger than during the financial crisis, in October 2008. The losses were significant: 10-year Treasury yields rose and prices declined. Stocks also suffered, proportionally more in emerging markets (EMs) than in developed markets (DMs). Commodities were also hit.
… is blurring the longer-term trend: bonds over-performance. Over the past 2 years, however, a broad macro-trend has been playing out. Below-potential growth and high liquidity pushed investors into bonds. Yes, stocks were generally up, performing better in DMs than in EMs. In Japan, lifted by Abenomics (large monetary and fiscal stimuli to kick-start economic growth), stocks climbed more than 40 percent. In the US stocks rose about 20 percent, in the UK and Germany about 5 percent, while Europe’s peripheral markets lost more than 20 percent. Asia, with the exception of ASEAN markets, did not perform well, with China down almost 30 percent and Hong Kong down 9 percent. But – over the same period – government bonds over-performed across the board: in most countries 10-year Treasuries were up more than 90 percent: above 99 percent in Japan, more than 98 percent in Germany, almost 98 percent in the UK; more than 97 percent in the US; almost 96 percent in Italy and more than 95 percent in Spain. In a global context where there is: 1) low growth and subdued inflation; and 2) abundant policy-induced liquidity, if the past is of guidance, this trend is likely to continue.
1. Low growth, subdued inflation, globally. Yet to recover from the 2008-crisis, the world still faces below-potential growth prospects. In 2012, global output grew at about 3 percent (a half a percentage point below the pre-crisis long-term trend), is expected to grow at the same levels in 2013, and is likely to remain below-potential until the developed world pays down sovereign and corporate debt, and emerging markets undergo needed structural transformations. As deleveraging constrains the recovery, the industrialized world is likely to suffer from high unemployment, frail consumer confidence and weak demand. Via trade and financial links, the slowdown is affecting emerging economies, where economic data point to structural weaknesses. After 2008, both developed and emerging markets have experienced a decline in their trend growth, to a lower level – by 0.6 percent and 1.8 percent respectively. No letter in Roman alphabet captures the post-2008 growth pattern. Rather than a “U”, “W”, or “L”, it looks more like an “inverted square root” (Figure 1). It might take a few more years before global growth regains its rising long-term trend.
Figure 1. An inverted square root: lower growth ahead
Source: Author, 2013.
Despite high liquidity, disinflation to persist; inflation unlikely any time soon. Inflation is low across the globe. Going forward, disinflationary pressures are likely to outweigh inflationary ones. Because of a combination of below-trend GDP growth and high unemployment, unused capacity in good and labor markets are likely to override upward pressure on prices, mostly driven by rising food and oil costs. Additionally, several factors will reinforce downward pressures, such as private sector deleveraging, reduced bank lending, cost-containment, productivity increases, and demographics – as older people have lower spending propensity.
In this environment, corporations are on hold. As sales, profit margins and corporate earnings might suffer, the corporate world lacks the confidence needed to make significant business and investment decisions. Unable to properly assess the economic outlook, businesses are reluctant to make longer-term choices about adding workers and capital spending. As business confidence suffers, firms remain unwilling to invest and tend to choose leaders oriented to cost-cutting rather than expansion. Large companies, even when cash-rich, contain capital expenditures and cut corporate research and development. Small and medium-sized firms, a major source of job creation, lost access to capital.
Lack of globally coordinated policies is not conducive to a growth pick-up. At the global level, there is a lack of policy action to resolve structural imbalances, restore fundamentals, and sustain growth. Both G-20 and G-8 have proven rather ineffective and multilateral policy coordination is generally constrained. Most countries are focusing on domestic issues, struggling to handle economic weakness and political challenges. As a result, the path to global rebalancing is likely to be uneven and will lead to lower growth. While developing economies need to spend more, a rise in private consumption is likely to take years. Reducing savings entails cultural changes and difficult policy reforms, such as boosting household income and strengthening safety nets. As advanced economies save more, fiscal consolidation – ongoing in the EZ and upcoming in the US – will reduce economic activity. In sum, the upcoming drop in consumption in advanced economies will not be offset by final demand in emerging markets, where most countries still rely on export-led growth.
2. Abundant policy-induced liquidity. Between 2009 and 2013, massive fiscal and monetary stimuli prevented a depression, by transferring debt from private to public agents via bank bailouts and central banks’ balance sheet expansion. Most governments’ debt-to-GDP ratios rose above 90 percent. The world’s eight main central banks – US Fed, People’s Bank of China, European Central Bank (ECB), Bank of Japan (BoJ), Bank of England (BoE), Germany’s Bundesbank, Banque de France, and Swiss National Bank – tripled their combined balance sheets from $5 to $15 trillion (Figure 2).
Figure 2. Central Bank Assets (% 2008 GDP = 100)
Source: IMF, Central banks websites, 2013.
Central banks cannot create growth; they can at best prevent it from dropping. Monetary authorities now bear most of the policy-making, but are in experimental territory. Going forward, monetary expansion will increasingly be less effective in stimulating aggregate demand, hence unlikely to achieve job-creation.
Remember Japan’s “widow makers”? Past experiences have shown that a context characterized by low growth and high liquidity increases the appetite for bond purchases, regardless of the presence of growth-impairing structural issues. In Japan’s well-known case, government bonds (JGBs) yields declined over the past 15 years, despite debt-to-GDP ratios at more-than-twice the size of the economy and a rapidly ageing population. Why such a counterintuitive development? Because JGBs had more buyers than sellers. While 95 percent of JGBs are held by Japanese, and local pension funds accumulate long-term JGBs to match their liabilities, banks were the largest buyers. Facing anemic growth and deflation, companies refrained from investing, paid off loans and kept cash into their bank accounts. Banks, facing a scarcity of worthy borrowers, parked their deposits into JGBs. Shorting JGBs, nicknamed the “the widow-maker”, proved financially fatal, at whatever yield the trade was made: 3 per cent in 1996, 2 per cent in 2002, 1 per cent in 2011. Investors kept flocking to the bonds, pushing yields down and prices up. Every year, Japan was able to borrow more cheaply. Indeed, over the past five years, despite yielding less than 2 percent, JGBs have outperformed US and German bonds. Bond traders betting against JGBs lost, spectacularly.
The world is Japanizing. The world economy may be in the middle of a lost decade. Following the Japanese pattern, in both DMs and EMs government bond yields have fallen even as debt levels have risen. Global growth is likely to languish below potential for a few more years. In the US, the Fed’s assessment of the economy might prove too optimistic: recently, Q1 GDP was revised down from 2.4 to 1.8 percent. Inflation, at around 1 percent is far from the 2 percent target. Unemployment is unlikely to fall below 6.5 percent over the next few months. In other words, liquidity injections are likely to continue. In Japan, the BoJ announced its intention to eradicate the country’s long-lasting deflation by doubling its holdings of JGBs over the next two years. The ECB announced it will maintain monetary support for the foreseeable future and left unchanged its refinancing rate at a record low of 0.5 percent. True, in the US, EU and Japan, bond-buying is keeping long-term interest rate down, helping the process of household and company releveraging. However, the impact on growth is small. More importantly, debt is crowding out credit: to repair their balance sheets banks prefer not to lend to risky borrowers, and focus on their own releveraging – by borrowing from the central bank and buying government bonds. Anemic credit growth keeps growth below-potential and fragile, calling for central banks’ to support the recovery with sustained easing. This process is likely to keep going until most banks are releveraged.
Investment implications: hold the bonds. With respect to the past decades, investors face a very different, and more difficult, investment environment. The probability of future financial shocks, and black swans, is high. Capital preservation via a defensive asset allocation is priority. Going forward, bonds are likely to keep outperforming stocks. No doubt, the bond market has grown increasingly complacent, and most analysts are concerned about its over-valuation. Inflationary expectations are on the rise, and government-bonds investors are facing negative real yields. But the factors that push demand for public debt are still there: stagnating growth, disinflation, private sector deleveraging, liquidity, skepticism about risk-assets, and banks in need of balance sheet repair. Also, most central banks want commercial banks to releverage, support bond markets and keep long-term interest rates at low levels. As long as this powerful combination is there, the bubble-in-the-making is unlikely to burst. Banks and investors are likely to keep parking central-bank-liquidity in bonds. The recent market correction could become a buying opportunity. Indeed, during the June bond selloff only a fraction of the money outflows was reallocated to equity funds. The bulk went into cash, bank products and money-market funds. If we look at Japan’s experience, we should expect banks to invest that liquidity into further bond-buying.
 Over the last month, 10-year Treasuries bonds lost almost 20 percent in the UK; more than 15 percent in the US; more than 13 percent in Germany; almost 8 percent in Italy; about 4 percent in Spain; about 3 percent in Japan.
 Over the last month, in China, Shanghai lost about 13 percent; Hong Kong’s Hang Seng declined about 7 percent; Singapore lost almost 4 percent; the Asia Dow lost about 1 percent; in India, the Sensex lost about 1 percent. In the UK the FTSE 100 lost about 4 percent. In France, the CAC 40 lost about 5 percent. In Germany the DAX more than 4.5 percent. In Italy the FTSE MIB lost 10 percent. In Spain the IBEX 35 lost about 5 percent. In the US, the DJIA lost more than 1 percent; the Nasdaq almost 1 percent; the S&P 500 almost 2 percent. In Japan, the Nikkei 225 rose more than 5 percent.
 Over the last month, gold lost more than 11 percent, and corn almost 10 percent. Crude oil gained more than 6 percent.
 Over the past two years, in Japan, the Nikkei 225 rose more than 41 percent. In the US, the Nasdaq rose by 22 percent; the S&P 500 gained more than 20 percent; the DJIA rose by 19 percent. In Germany, the DAX rose more than 6 percent. In the UK, the FTSE 100 rose about 5 percent. In France, the CAC 40 lost about 6 percent. In Spain the IBEX 35 lost more than 24 percent. In Italy, the FTSE MIB lost about 25 percent. In China, Shanghai lost almost 29 percent. Hong Kong’s Hang Seng lost more than 9 percent. Singapore was flat at a less-than-1 percent gain. In India, the Sensex rose only about 4 percent, below inflation.