The Importance of 1.34%

Blain’s Morning Porridge – 8^th July 2021: The Importance of 1.34%

“How many impossible things can you believe before breakfast?”

This morning – US 10-year bonds and US equity are in full rally mode. They show contradictory expectations for a stalled recovery and future strong growth! How can that be? Because the market is about what participants collectively think – and how markets think has been utterly changed by 12 years of monetary experimentation, repression, and distortion. We’ve got to change the way we think about markets.

It’s a bit quiet in the City of London this morning. It’s because no one can speak after cheering so loudly for Engerland last night. I’ve already had a Dane complain – he hadn’t seen Sterling dive like that since 1992. Whatever, this Scotsman will be supporting England on Sunday… but I refuse to sing the song… (And, of course, Scotland is the only team England has failed to beat!)

Apologies for the lack of Morning Porridge yesterday – but getting up to London was more problematical than expected; letting Virgin into the house for another go at the broadband, carting the puppy off to the puppy hotel (apparently he’s been chased by chickens!) and then the sheer performance of trying to buy a parking ticket in Winchester rail station… Life is never easy.

But it was worth it! I saw a number of City chums for the first time in 15 months. Beer was drunk. Lots of catching up, lots of stories and lots of banter… And then, Martinis in Dukes where Alessandro makes the best Martini on the planet – an undeniable fact! I’m going to do it all again today – without the Martinis. (It’s fair to say, I am feeling a tad dusty this morning….. maybe it was the hotel bed?)

And sometime during a discussion on markets my chum, CIO of a very large family office, spotted something interesting:

• The yield on the 10-year US Treasury Bond was exactly equal to the Dividend Yield on the S&P 500. Both were 1.34%.

That is a critical number. It may even be as significant as the answer “42”.

What do declining US bond yields and falling stock dividend yields tell us?

That the reflation trade is fading fast? Falling bond yields = rising bond prices, and are a sign the market anticipates a slowdown and declining inflationary threat.

Yet, we still expect to see further equity upside? Falling dividend yields = rising equity prices, and are a sign the market anticipates strong growth and rising corporate profits.

In bonds there is truth. Bonds are about credit risk – getting repaid principal and interest. But not the US treasury market – which is why it is called the risk-free rate. The risk of holding a Treasury bond actually boils down to inflation risk. Whatever mad-eyed Libertarian preppers hiding in mountain lairs say, the US Government defaulting on debt is a 50 Sigma possibility – it aint going to happen.

But inflation will eat away the value of the bond today in terms of its purchasing power relative to its future purchasing power at maturity. The greater inflation, the less the bond is worth, and its price today should reflect that. Inflation could occur through rising prices, and declining confidence in currency which creates inflation as its FX value tumbles.

If you assume zero inflation – as the market clearly does when the 10-year risk free rate is 1.34% – then there is no downside risk holding Treasuries. You will happily collect $1.34 for each $100 invested semi-annually and the price of a beer or a McDonalds in 10-years time will be exactly the same as it is today. (Which it won’t.)

Bonds have rallied strongly in recent weeks – clearly telling us the expectations of a strong global recovery have stalled. There is little upside to holding bonds. Just certainty. If the global economy does staggering well… you won’t get $2 back on your $100 investment. The only way you get more at maturity is if we see deflation – when the price of a beer is less in 10 years time than it is today.

Yet, we all know the world is a very uncertain place – its been illustrated by supply chain shifts and breaks, and rising trade hassle and protectionism. Inflation is not only likely – but nailed on. And that means any pension fund buying bonds today to pay your pension tomorrow – is going to fail… unless they find other ways to generate returns.

It’s the same problem if they buy equity. Long term, bonds outperform, but today we believe stocks are the only place to generate Alpha. If you want upside, then buy stocks. If the global economy rallies and grows, then profits rise and companies become more valuable… yada, yada… The downside? If the global economy stalls, companies make less money, the price falls or they collapse completely and you get nothing back.

How can the two markets be telling us such a contradictory story?

Distortion is a terrible thing. It affects minds and they way we think about markets.

And this is what I suddenly realised yesterday talking to my chums yesterday. We all noted the same thing – those of us of a certain age are watching younger, more nimble financial minds take over our business. That’s normal. They have different perspectives and different reads on what’s happening… and No One Working In Global Finance Today Under the Age of 32 has ever known markets that were undistorted by QE!

Think about it a second – central bank policies holding interest rates artificially low and them standing ever-ready to support global markets from the consequences of induced bubble conditions – have been the dominant theme of market for 12 years now. A whole generation of very clever bankers and investment managers are maturing into senior positions across the global financial industry having known nothing else.

It amazes me in our own internal discussions how the divide between we few surviving old fogey’s who remember free market currency crashes, bond market collapses and equity tumbles, and the younger financiers who can just accept the distortions caused by central banks to avoid these events, as a factor to include in their market expectations..

That’s probably why anyone over 40 is such a bear and convinced the market is unsustainable, while the younger generation is far more accepting of distortion as a permanent market reality..

Remember… when it comes to generating investment returns, it’s not what you think, but what the market thinks that matters. It is just a voting machine…

(And, by the way, the only way funds are going to make proper returns in these markets is probably to shift out of distorted financial assets (bonds and equity) and start buying real world assets linked to reality… that’s a story for tomorrow!)

Five things to read this morning:

ZH – Delta Could Disrupt Recovery Warns Goldman

FT – China’s rival to battle Boeing and Airbus for the skies

FT – China’s crackdown threatens $2trillion IPO market

WSJ – American Stocks have lost their Exceptionalism – Except Big Tech

CapX – Nissan’s new Gigafactory will be a monument to dead-end tech

Out of time, back to the day job… and looking forward to my next trip to London!

Bill Blain

Strategist, Shard Capital