The flight to quality into government bonds, in particular into US Treasuries and German Bunds, has left many investors wondering about their asset allocation between fixed income securities and equities. In the following article I will dig into the expectations from both markets, the divergence in opinions between investors and how you can benefit from it.
The flight to quality has crippled long term government bond yields. The 10 year US Treasury now yields a mere 1.45% while the German 10 year Bund yields just 1.17%. Despite the fact that inflation rates at both sides of the Atlantic are around or above the 2% level, which implies they buyers receive a negative real interest rate, investors are happy to continue to poor money into these securities.
Part of the continued flight into government paper has to do with banks cleaning up their balance sheets, reassuring investors that they only invest the in the best graded paper. Many bond funds also shift their holdings within the fixed income area towards best quality paper and in recent weeks we furthermore see a massive asset re-allocation from equities and other investment classes into bonds.
Deflation or Inflation
So what do these negative real interest rates for long term government paper tell us? Are people expecting low inflation or even deflation or has the massive allocation towards the high-rated paper created an inefficient market as market participants need to strengthen their balance sheets?
Ever since the severe recession as a result of the financial crisis of 2008, investors have been worrying about the possibility of deflation. While we have briefly seen a deflation period (just for a couple of months) amidst that crisis, inflation picked up rather quick as the economy stabilized and started a slow recovery. Inflation has traded around the 2% mark for a while, in recent official numbers inflation is estimated to run at 2.5% per annum. The pullback in recent weeks in commodity prices will likely have a softening impact on inflation, but the falling prices of oil and other key commodities are not nearly enough to worry about deflation in the short term. In comparison, when we briefly experienced a period of deflation amidst the crisis of 2008 oil prices have fallen from a peak of $147 in 2007 to $40 in about a year, a 75% decline. The recent correction in WTI from $110 in February to $83 at the moment "only" implies a 25% decline.
So are US investors happy to lose 1% per year in real terms by investing in 10 year bonds? We have just seen that the correction in commodity prices has been rather limited compared to 2008 and furthermore the economy is still growing. However given that bond markets claim they are more informed than equity markets, are they still worried about deflation as economic growth is slowing down in the US, Europe and China/Asia at the same time and governments have maxed out their stimulus capabilities?
Everyone is levered
It is important to realize that most market participants including banks, governments and consumers are still very much levered. Only the corporate sector is in good financial health. As such most participants are most fearful of a scenario of a new recession combined with deflation as it increases the debt load in real terms. As such central banks, most likely urged by politicians, would most likely start to print extra money, or inject additional liquidity in the financial system to keep it afloat. It remains however the question whether this will create a significant uptick in inflation.
The actions of the central banks over the last years have failed to create significant inflation as the output gap in the economy never really got closed. Central bankers are still in uncharted territories and their innovative methods of supporting the financial system have never been tested in real life leaving many puzzling about the impact for possible inflation. So while authorities will try to avoid deflation at any costs the likelihood and degree of inflation these policies can cause, remains yet to be seen.
Bonds Versus Equities
Many market participants thought that the maximum price a bond could reach was to discount all of its payments, coupon and the principal at maturity, at 0% interest rates. However in recent weeks we have seen negative yields for bonds. The Swiss 2 year Note traded with a negative nominal interest rate of 0.28%. This proves that the conventional wisdom of having "an absolute upper limit" on bond prices is simply not true.
Should you get into bonds then?
Does this new observation imply that you should rush into bonds as well? I highly doubt so. Investors who buy long term bonds now are either bettering on a deflation scenario in which the government fails to print enough money to create significant inflation. Other buyers simply follow the "greater fool theory" betting that other investors will pay up even more for bonds and natural buyers are banks who have a positive carry from LTRO programs from Central Banks and need to clean up balance sheets. With the fools and banks on the bid in government bonds, we have created an artificial demand for these bonds which most likely drives up their values above the "fair" price.
Equity vs. Bonds puzzle
The great divergence between bonds which have been sky-rocketing and share prices of highly credit worthy companies, which have been falling, have left many investors puzzled. Large credit-worthy companies trade at fairly low valuation multiples and carry high dividend yields. Investors are getting confused. If they invest in a basket of financial strong companies paying a 4% dividend yield, those investments have a positive carry of the dividend minus the government bond yields. This positive carry is equivalent to some 2.5% at the moment, while equities have a natural upside potential vs. the rather limited upside potential in government bonds. Remember that investors are not willing to pay any price to bet on deflation, as they could simply hold on to their cash.
Invest In Large, Financially Strong Companies
So what are investors afraid of? Of course a severe recession or possibly even global depression will lead to dismal profitability or even defaults in the corporate sector. But given that many corporations seem to be in better shape than their own governments how can we rime this situation? While governments can switch on the printing press, this does not have to be a bad thing for corporations. So investors should look for corporate investments which meet the following criteria:
- They need to be highly diversified in geographical terms to rule out expatriation risk
- High profit margins and a variable cost structure are preferred allowing companies to remain profitable even during significant declines in demand
- A strong balance sheet with large net cash positions and little debt are preferred
Based on these criteria I immediately think about the global technology and internet sector. Companies within this industry have proven to be resilient during downturns, are typically very global in their operations, they have a strong balance sheet with piling cash balances and most important most companies operate with a variable cost structure leaving them less exposed to possible losses during revenue downturns.
Basket of 5 tech moguls
Let's have a look at some of the bigger technology related names which largely as a whole meet the criteria which I just set out.
Apple (AAPL) has a market capitalization of $525 billion and it holds a net cash position of $110 billion. It reported a net profit margin of 24% for 2011 and its pays an annual dividend yield of 2.6%
Cisco (CSCO) has a market capitalization of $85 billion and it holds a net cash position of $32 billion. It reported a net profit margin of 15% for 2011 and its pays an annual dividend yield of 2.0%
Google (GOOG) has a market capitalization of $186 billion and it holds a net cash position of $44 billion. It reported a net profit margin of 25 % for 2011 and its pays currently no dividend.
Intel (INTL) has a market capitalization of $126 billion and it holds a net cash position of $6 billion. It reported a net profit margin of 24% for 2011 and its pays an annual dividend yield of 3.3%
Microsoft (MSFT) has a market capitalization of $239 billion and it holds a net cash position of $41 billion. It reported a net profit margin of 33% for 2011 and its pays an annual dividend yield of 2.8%
On average these companies hold a cash balance of 20% versus their market capitalization with large net cash balances across most firms. These companies report large positive operating cash flows and superior net profit margins of 24% on average (remember this is after tax). Additionally the basket pays a dividend yield of 2.1%, providing investors with a positive carry versus a long bond position.
How to benefit from the current situation
Investors! Don't get trapped into the greater fool theory by chasing bonds now in an effort to feel "safe". The disconnect between bond and equity markets has grown so much that a balanced long equity position in combination with a short government bond position is my preferred trade. Of course investors will benefit handsomely if the economy and stock markets recover, but the losses in case the situation deteriorates are expected to be limited. In my opinion the market is mispricing this and offers equity investors with free call options.