Brent Sheather: Racing to zero?

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Probably the biggest surprise in the financial world last year, apart from Xero's share price getting pushed as high as $44.75, has been the fact that longer term interest rates around the globe, with the exception of those in Greece, the Ukraine and a few other dodgy countries, have moved sharply lower despite the conviction amongst journalists and stockbrokers at the start of the year that they would rise.

For example (see graph) ten year US government bonds were 2.96 per cent early in January 2014 and a year later they are around 1.8 per cent. In Europe things look even more dire with short dated German government bond yields negative and the ten year maturity having moved from 1.89 per cent in January 2014 to just 0.40 per cent a year later.

These are ominous signs - the market is clearly concerned that the world may be caught in a deflationary trap. This is all the more worrying because, despite massive stimulation involving quantitative easing in the US and similar moves in China and Europe, economies and inflation remain sluggish, debt levels have hardly changed since the GFC, and the markets are starting to contemplate that a deflationary episode may be unavoidable.

This environment would have huge implications for investment portfolios as high quality bonds generally do well when economies contract and the share market does badly.

A number of recent reports by non compromised, non-biased experts with no investment banking affiliations warn of potentially dangerous times ahead. Starting with Gavyn Davies, Chairman of Fulcrum Asset Management, in his recent FT blog looks at the recent "volatility" and his view is that the rationale for lower stockmarkets and lower bond yields reflects a decline in "medium term GDP growth expectations throughout the global economy" and a risk that secular stagnation à la Japan may be inevitable.

Davies also suggests that financial markets could be starting to doubt whether the world's central banks have the weapons required to off-set deflation and warns that "if markets start to doubt this they have entered much more dangerous waters".

Writing in the Grants Interest Rate Observer James Grant quotes a paper by the International Centre for Monetary and Banking Studies which makes the point that, despite the GFC, debt levels have kept on rising and now the ratio of world debt to world GDP, excluding financial debt, is up to an unprecedented 212 per cent with emerging market governments borrowing heavily of late.

The report says China is the "elephant in the room" as Chinese debt has now risen to comprise 220 per cent of GDP. It makes the point that previously China had borrowed to invest in export capacity but since 2008 it has borrowed to stimulate the local economy with uneconomic investments like the construction of apartment blocks in uninhabited cities generating no income, prominent.

The only good news is that Chinese borrowing has been financed by local investors but it notes that a Chinese credit crisis would be transmitted to the rest of the world by way of a shock to global exports. This explains the recent weakness in the iron ore price and the A$. Martin Wolf, in the Financial Times, argues that "we have made a Faustian bargain" in that there is no obvious escape from quantitative easing once it has begun and QE seems to blow bubbles in parts of the economy that require further QE to ameliorate their outcome. The end game could be nasty.

These are all relatively novel features of the world economy but some commentators cite long term factors as being responsible for their view that "the world we are in now is structurally disinflationary". This is the opinion of demographics expert Richard Hokenson writing in the CFA Institute Magazine. I must disclose that the heading for this story came from Mr Hokenson's paper. He says that demographic factors - the aging of the world population - crushes inflation.

Population growth rates peaked 30 years ago and have been slowing ever since so the rate of growth is slowing. His view is "we are on a secular race to zero" and that the 10 year US bond yield will hit a new all-time low (previously 1.47 per cent in July 2012) before 2020. His conclusion is that the risk of deflation is much greater than inflation and a deflationary scenario implies declining asset prices where the only asset class that will do well is the highest quality bonds. Recently one writer made the point that the 1920/21 depression was preceded by collapses in commodity prices.

Contrast these pessimistic views with the continued bullish rhetoric from local investment experts. How should Mum and Dad, retired and living off their savings, manage their fixed interest portfolio? First off they should ignore any financial advisors, journalists or experts who tell them that interest rates are too low and therefore they should not own long term bonds.

Goodness knows how much money has been lost as a result of that advice. Many people make the mistake of looking at where interest rates have been, where they are now and concluding that because they are lower now they should go up. (Behavioural scientists know this is a common mistake investors make and they call it "anchoring"). Interest rates may be too low and they may rise but equally they may not. Given that interest rates represent the consensus view of the many experts comprising the "market" as to the price of money one should not disregard their verdict lightly. Modesty can be a useful attribute for investors!

Instead Mum and Dad should look at best practice as indicated by the portfolios of pension funds and ensure that they have a sensible weighting in high quality long dated bonds as an insurance against a deflationary event, or worse. They should also make sure, and this is just a common sense approach which should be employed at all times, that their equity portfolios are highly diversified, overweight positions managed and understood and there should be no exposure to individual stocks in markets outside NZ and Australia.

The other big risk to the world economy is the high levels of debt in China and if there were a problem here the western stock market with the most to lose is arguably Australia so investors should be well diversified outside that market.

With any luck the deflation risk is already priced into equities and bonds and things will get better. A best case outcome thus would be small losses incurred on the long bond portfolio in the medium term as the world economy bounces back and inflation takes off. But don't bet the house on that scenario - plummeting commodity prices and bond yields are a warning sign.

Brent Sheather is an Authorised Financial Adviser. A disclosure statement is available upon request. Brent Sheather may have an interest in the companies discussed.