Back in the early 1980s, I was just starting my career in bonds and found myself attending a friend’s wedding where many of the other guests also worked in the investment industry. Despite the happy occasion, I hardly felt festive as the preceding week had experienced successive limit down days in the bond futures pit of the Chicago Board of Trade. At the time, being new in my career, I thought for sure I would be looking for a new job when I returned on Monday. To my surprise, hardly anyone mentioned the markets; everyone was having the time of their lives, acting as if nothing had changed. These many years later, with the benefit of hindsight, I recognize there are relatively few times in life when momentous change happens. Today, it is abundantly clear that the outbreak of the coronavirus (COVID-19) is dramatically impacting our daily lives and the economy at large. It is easy to overreact to the volatility of financial markets. Yet, the end of the world only occurs once, and this most likely is not it.
Forty years in the investment business has taught me several lessons. Some of which I learned from and others that I wished I had. For example, you should always expect the unexpected, and anything can and will happen given enough time. Moreover, financial markets are an expression of basic human emotions – the most significant being fear and greed with rationalization, a close third. We demand certainty when often there is none. All the expert opinions aside, no one knows how the coronavirus crisis will end and I am not sure it matters. With certainty, it will end or be brought under control. Even if we knew more about it, I am not sure we could do anything about it. A wise friend of mine once said during the 2008 financial crisis, “the body will heal.”
My career in the bond market began with short-term interest rates at 20% and long-term interest rates at 15%. At the time, economists and investors believed that the path for interest rates was up. Inflation was a major risk. Most economists feared that real rates were too low. They feared that double-digit nominal interest rates were not adequate compensation for the risk of inflation. Ultimately, real rates were, in fact, too high to sustain high inflation. Fixed-income investors were compensated handsomely for bearing inflation risk. Equity managers, who assumed that earnings were a natural inflation hedge benefited more from a declining discount rate than an earnings boom.
Most investors in the 1980s feared that the Federal Reserve was behind the curve and had lost control of inflation. In his determination to clear markets, Federal Reserve Chairman Paul Volker proved them wrong. Markets have a way of self-correcting. Inflation turned out to be less of a problem. The invisible hand proved to be the solution. Prior attempts by policymakers to control inflation proved foolhardy.
Today, the secular decline in inflation has led to an unprecedented boom in financial markets. Stock and bond returns have been spectacular. Given the rapid decline in interest rates, bond returns have kept pace with equity returns. Equity returns have been driven as much by earnings growth as the discount rate used to determine their net present value. The expansion of credit under the low-interest rate scenario has allowed corporate leverage to grow, facilitating M&A activity, and stock buybacks.
The 2008 financial crisis was the result of too much of a good thing. Lending became lax. Valuations became stretched. Markets looked ready to self-correct, but policymakers were unwilling to bear the pain, and instead pursued policies to promote growth through lower interest rates and government subsidy prolonging the cycle. The persistence of lower rates forced savers to become investors and investors to become speculators.
Government policy has promoted the bull market in risk assets since the financial crisis. Stock markets are no longer a reflection of economic activity. Instead, they have become an instrument of policy to promote economic activity. Strong stock markets are no longer an indication of investor sentiment but required to sustain confidence.
Policymakers appear committed to whatever is required to maintain main street growth. As a consequence, they must keep stock prices elevated. Their policies designed to defend debtors have damaged capitalism. Under market capitalism, some pain is necessary for there to be gain, but under managed capitalism, the opportunity set is highly constrained. Savers are forced to be investors, and investors must become speculators. Higher risk preferences are required to earn adequate returns. Real rates are extremely negative, and investors are not well compensated for risk. The inflation risk appears mispriced, given the expected fiscal and monetary stimulus needed to support stock prices. Negative interest rate policies are a desperate attempt by central banks to force inflation higher. What if they are successful?
While higher inflation holds the potential to deleverage the system, it has been challenging to achieve. Monetary policies so far have at best delayed a deflationary bust. Eventually, like in the 1980s, the markets will experience a clearing event paving the way for a more inflationary environment. We may be in such a period currently.
Given the risks, investors must focus on higher-quality investments. Developed country sovereign debt no longer represents an attractive hedge. Investors must turn to sovereign debt from countries outside the G-7. They may be surprised that these investments are attractive relative to alternatives. Sovereign debt experiences fewer defaults and better recoveries than similarly rated corporate bonds. Given the added leverage amassed this cycle, corporate bonds are incredibly vulnerable to downgrades. The quality of sovereign issuers of similar rating is arguably slightly better than its corporate cohort. Unquestionably, there is a diversification benefit.
Technically, sovereign debt from developing countries is an emerging asset class that is under-owned in most domestic portfolios. A mistake made by many US investors is giving in to the temptation of the higher yields offered by lower quality, local currency sovereign debt, which has resulted in underperformance. Today’s environment has not been friendly to those seeking higher returns from higher yields. Instead, investment-grade sovereign debt, denominated in hard currency, represents a unique asset class that continues to outperform most other strategies.
With all the headline obsession on what this global health scare means for stocks, it is easy to overlook opportunities. Things will improve eventually, but some patience is required. The policies to gain control of the virus and its economic fallout are starting to be better understood. Developed market policymakers are going to continue to do whatever they think is required through monetary and fiscal policy to stabilize things. The debt burdens that they are likely to incur will make them less creditworthy relative to high quality emerging market sovereign issuers. The yield spread advantage of the emerging market sovereign issuers will adequately compensate for the time it takes for their credit spreads to converge.
Volatility often presents opportunities in places where you are not looking. Not every opportunity is grand, requiring large bets. The idea of adding high-quality sovereign debt to a diversified fixed-income portfolio is not all that complex or risky. It is, however, timely and attractive. It is not likely to get the attention of your friends or make for fascinating conversation at a friend’s wedding, but it will lead to better risk-adjusted returns.
To download the PDF version, click here: 2020-03 The Body Will Heal
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