Could U.S. Treasuries be the best performing asset class of the next one-two years? It's quite possible. I am sure this article is bound to stir up controversy, but I'd like to spend some time analyzing several drivers that could buoy bond prices in the coming months.
Sub-par Global Growth
Global GDP has now been below trend since the fourth quarter of 2011. Real growth should be around 3% per year. Sustained periods above this threshold have generally been good for global growth proxies like commodities and emerging markets, while sustained periods below have seen an outperformance in defensive sectors and a bid to bonds.
Source: World Bank
Commodities turning down again
Indeed, the current cycle appears no different with the commodities peak clearly coinciding with the faltering global growth that began in 2011.
In our Battle article, we thought the Central Bankers' reflation attempts would have a much greater effect on short-term global growth and commodity prices going into at least early 2013. Though the reflation trade been short-term profitable for us, the outcome has been much weaker than we originally envisioned and now appears to be turning.
As we thought, bulls did indeed win the battle, but now it looks like it's time for the War to begin. The downturn in commodities is signaling another downshifting of global growth which puts a floor on bond prices.
Equity markets no longer provide an alternative
While global growth and commodities peaked in 2011, equities have been a source of strength. Global earnings have been in a slow, downward trajectory since 2011. As one would expect, earnings declines have been most pronounced in the EAFE, whereas the U.S. has been a bastion of strength.
The different earnings trajectories of the various global regions has been reflected in the relative share price movements, with the U.S. outperformance particularly pronounced over the past 18 months.
Thus far, the global earnings slowdown can be described as a soft-landing, but this was also the case in 2008 when global growth was stronger than the U.S. Today, we see a role reversal, as it now appears the U.S. earnings cycle is turning. U.S. Treasuries are one of the few alternatives against slow growth and earnings declines.
The U.S. macro-economy is tipping over
In some ways, the U.S. economy has supported the rest of the world. The U.S. still accounts for 50% of the capitalization of the MSCI World index and U.S. GDP is around 25% of the global total. Our economic growth and U.S. companies' profitability since 2009 has been a positive driver for global risk assets.
But it appears the U.S. economy could be succumbing to the global malaise, compounded possibly by internal fears over the consequences of future austerity aka "The Fiscal Cliff." This shows up first and foremost in capital investment, which appears to be hitting an inflection point.
Capital investment decisions by CFOs are long-horizon decisions. Clearly, U.S. executives see something amiss. Once inflection points occur, they last for a couple of years, and can be vicious as we saw in 2007-2008, or virtuous as we have seen in the past three years.
A turn in U.S. capital investment, and the knock-on effects, will have further negative ramifications for global risky assets and likely provide a floor on bond prices.
The sliver of good news is that given the upturn in Housing (albeit from depressed levels), it's possible the U.S. can avoid recession even if the rest of the world slips into it. But certainly the odds of a major growth scare in 2013 have now increased and markets generally tend to be anticipatory, with the first leg of a bear market usually occurring very fast and approaching losses of 20%. This can only be good for bonds.
Treasury Relative Strength
Finally, when we observe the strength of Treasuries, we see they continue to maintain their historical correlation to economic growth. Bonds have maintained their gains from the global growth scare which hit mid-2011 and are positive in 2012. But given the prospective earnings growth and capital investment outlook we have outlined, it's quite possible that moves since mid-2011 are the "appetizer," and that bona fide global recession may give us a massive bull run as the "entree."
To those who naively argue that a 3% yielding 30 year Treasury bond can only make you 3% versus negatively skewed losses, I'd argue that low-yielding, long-duration investments are exactly where you want to be in a global slowdown. Low-yield and long-maturity bonds have high duration, and essentially act like zero coupon bonds, hence giving an investor tremendous price appreciation if there is further flight to safety.
The chart below from Gary Shilling's The Age of Deleveraging shows that if 30-year bond yields were to fall to 2%, the potential gains could be 20%. Indeed, the circumstances for such a scenario would likely also be quite dire, hence the relative returns from bonds would be substantial.
Source: Gary Shilling
To others who think that a sub 1% 10-year or sub 2% 30-year US Treasury yield is impossible, I will simply point to a comparison of Japanese and U.S. bonds.
Also, if you're wondering where the 30-year JGB stands, I'll do one better and show you the 40-year bond, which as recently as 2010 hit 1.6% and currently stands just above 2%.
In our most recent Market Thermometer article, we said the market was at an important juncture and advised a move into defensives and fixed income. But ultimately we are reticent over having any stock allocation at this point, given the nosebleed valuations we see in the defensive sectors. For instance, as investors have chased high yield investments, they have pushed the S&P500 Utilities index to its highest price:sales and profit margin ratio since our data set began in 1993.
So ultimately we've thrown in the towel on the effectiveness of any further QE in elongating the business cycle, and for our traditional defensives versus cyclicals trade to work (on the basis of valuation and crowdedness), and have moved into a fully defensive posture shunning anything that is remotely related to positive global growth. While we like to trade tactically, this is a fundamental view, and represents the bias from which we expect to be trading for some time.
Our preferred fixed income investment is TLT. Contrary to the view of sell-side strategists, we think TLT is positively asymmetric at this point. Central Bankers have been able to cause a lot of volatility in the equity markets since 2011, hence making shorting high beta assets a dangerous game, but they cannot change the business cycle and the smart money appears to have strong hands in bonds.
Throughout these massive interventions to create inflation, TLT has been incredibly resilient, telling us that deleveraging forces are stronger than any Wizards behind the Curtain. That's the hallmark of a true bull market.