The probability of a rate hike at the December 16th FOMC meeting, as calculated by the market, now stands at 80%. Whether it actually takes place in a week, or whether the move takes place at one of the next two meetings, the consensus is that short-term rates will move higher soon. We have written over the past months, and even years, not only our view of when the Fed will raise rates, but also what the impact will be on the most rate-sensitive area of most portfolios: bonds.
Just yesterday I received an email that was likely similar to emails you have been receiving lately, from one of the many financial services firms who have taken it upon themselves to save our fixed income portfolios. The subject header read, “Is your fixed income portfolio prepared for rising rates?” The first line, in bold, warned me, “It’s the interest rate risk inherent in fixed income: when interest rates rise, bond values fall.” Based on the severity of warnings such as these, that we have all been subject to through news media outlets and the marketing divisions of asset gathering financial companies, I decided to do some digging to see just how “at risk” we truly are with regard to bonds.
In actuality, my “digging” involved updating a chart to which I like to refer that I think should relieve those concerned about rising interest rates. The chart below, using data compiled by Morningstar’s Ibbotson SBBI 2015 Classic Yearbook, shows that even during long periods of rising interest rates, US intermediate-term government bonds rarely exhibit negative returns: (Click on the chart for a larger version)
While the long explanation for these welcome results is related to duration and convexity (i.e. more is gained from a fall in yield than is lost when interest rates rise), the shorter answer is that total returns from bonds comes from a capital appreciation component and an income component. In a bond portfolio that is properly laddered and/or managed, maturing bonds are reinvested at higher rates, so that over time, higher rates mostly offset capital losses, even during rising rate periods.
An even more positive chart (pun intended) explores what happens to bond returns with longer holding periods. This data, also provided by the Ibbotson SBBI 2015 Classic Yearbook, demonstrates how holding assets for long periods of time has the effect of lowering the risk of experiencing a loss of capital: (Click on the chart for a larger version)
Throughout these 5-year rolling-periods there were times where interest rates undoubtedly rose for an extended length of time. In spite of rising rates, bonds have demonstrated a remarkable ability to preserve capital when held judiciously and through full market cycles.
It should be noted that here at Northwest Investment Counselors we invest primarily in corporate and US Government Agency debt securities. Agency bonds tend to move almost in lockstep with US Treasuries due to their implicit government guarantee, the major difference generally being the structure of agency bonds, many of which are callable, compared with plain vanilla, non-callable Treasuries. The above trends, while similar for all high-quality, investment grade bonds, are likely somewhat different for corporate bonds, with the notable difference being the higher return volatility of corporate bonds. Since they are inherently riskier, the returns in good years will be higher, and the negative return years will see more capital depreciation. Nonetheless, well-researched corporate bonds will offer many of the same portfolio stabilizing characteristics of US intermediate-term government bonds when held for long periods, while in most cases providing a higher level of income.
Please contact us directly to learn more about the contents of your bond portfolio specifically or to hear about our various fixed income solutions that provide income while also matching cash flow with liabilities.
As China’s markets fall and drag down global equities, the underlying concern is undoubtedly how much a slowdown in the Chinese economy will affect the rest of the world. Since the 2008 global financial crisis, China has notably emerged as one of the twin engines of world growth.
China has contributed as much to world GDP growth as the US in the past decade and a half, and even more than the world’s biggest economy since the 2008 financial crisis, according to the IMF. Indeed, the IMF projects that China will generate around double what the US contributes to world output until the end of the decade. Together, the US and China are expected to generate as much world output as the rest of the world put together.
Prior to China integrating with the world economy, the US was the biggest and sole engine of global growth as it accounted for nearly a quarter of world GDP, based on market exchange rates. So, it’s the rapid growth of China, which rose from accounting for a mere 2% of world GDP in 1995 to around 15% now, that helped the world economy grow so quickly in the 2000s.
As China slows from the nearly 10% growth rate that it clocked in the first three decades of its reform period, which began in 1979, to what is thought to be a more sustainable 7% or so, the world economy is likely to slow with it. The main areas where the impact will be felt would include not only commodities, but also consumer goods, including luxury goods.
China’s re-balancing of its economy means that consumption (what consumers buy) will become a bigger part of the domestic economy than investment, and services will become a more important driver of growth than manufacturing. As a result, a Chinese slowdown will affect not just commodities and capital goods, but also global consumer demand and thus the profits of multinational companies in America and Europe. Here’s a breakdown of the most affected:
1. Commodities exporters
The countries most affected by a Chinese slowdown are still likely to be those that export a great deal to China, notably commodity exporters such as Australia. As Chinese demand for raw materials and commodities decline, there will be a knock-on effect in terms of their economic growth.
For Australia, China accounts for around one-third of all exports.
For Sub-Saharan Africa, China is the the largest trade partner, accounting for around one-eighth of all trade. But the impact will be concentrated since five countries account for three-quarters of all of Africa’s exports to China: Angola, the Democratic Republic of the Congo, Equatorial Guinea, Republic of Congo, and South Africa.
China has surpassed the US as the most important trading partner for Latin America, which has traditionally been seen as America’s backyard and therefore most susceptible to the economic fortunes of its northern neighbour. But that is no longer the case. Latin American exports to China have risen to account for a record 2% of the GDP of the region.
As China’s growth slows, its imports have fallen by 8% from a year ago, as seen in the latest data for July, following a similarly sizeable 6% drop in June. The slowdown has been felt in the commodity price falls seen throughout the summer that has led to tens of thousands of job losses by oil and coal companies globally, as well as others.
But, it’s not just commodities. Capital goods imports have also fallen, which will affect countries like Germany where exports to China account for around 2% of GDP. Germany itself accounts for the bulk of EU exports to China so the largest country in Europe, which has recovered on the back of exports, will also feel the impact.
Indeed, the European Union is China’s largest trading partner, and China is the second-largest trading partner of the EU after only the US. So, a slowdown in China will affect Europe, which is also felt in the profit warnings issued by European companies such as Burberry and BMW as their sales in China slow.
3. The USA
But that doesn’t mean that American multinationals will be unaffected. For instance, the world’s most valuable company, Apple, sells more iPhones in China than the US, and its CEO has reassured markets more than once that the Chinese slowdown won’t negatively affect their business.
4. Financial markets
Finally, the Chinese slowdown has been most visibly seen in financial markets. China’s stock market is largely closed to outside investors so does not have a direct impact on global investors. But, despite rebounding from their initial fall, equities markets are certainly reacting to the impact of a Chinese slowdown.
The UK’s FTSE will feel this most acutely, as it has a large portion of commodity stocks and around half are multinational companies, making it one of the most open bourses in the world. No wonder UK stocks experienced their worst one-day fall since the 2008 financial crisis when China’s market tanked.
Undoubtedly it’s unusual for the world’s second-largest economy to be a middle-income country that is not entirely market-driven. Given the importance of China to the world economy, it’s time to get used to monitoring China as well as the US even more closely and becoming accustomed to the greater ups and downs that are likely to be seen in the global economy as a result.
Scott Grannis of Calafia Beach Pundit blog has an excellent piece on China’s currency move which you can read by clicking the link. Below we show his chart of the real value of the Yuan to keep the longer term in perspective. He writes, “Over the past 20 years, China has strengthened its peg vis-a-vis the dollar considerably, from 8.4 yuan to the dollar to now 6.3. As the chart (below) shows, the real value of the yuan against all other currencies has doubled in the past 20 years. So it’s fair to say the yuan has been an incredibly strong currency for the past two decades. That it should drop 2% against the dollar is hardly noteworthy. Maybe it was just too strong, and now it’s a little bit less than ‘too strong.'”
Gold prices have tumbled to a five-year low. As a tradeable commodity, the price of gold is largely linked to supply and demand. While supply remains fairly fixed, demand is shaped by the state of the global economy and investor perceptions of gold’s value as an asset – this is in turn shaped by the strength of the US dollar.
The intrinsic value of gold has long made this precious metal a useful resource in the absence of legal or reliable money. The ease at which gold may substitute for currency means that during turbulent economic times gold is a valuable asset to hold.
The love affair with gold as a financial instrument can be traced back for centuries. A more recent example which offers lessons in the relationship between the commodity’s value and the US dollar is the Bretton Woods System, the monetary order which governed international currency relations between 1944 and 1971. With the growth of international trade after World War II, many countries were happy to hold US dollars in reserve, given they were convertible into gold at a rate of US$35 an ounce. And, with the US owning three-quarters of all gold reserves at the time, a US dollar was as good as gold.
An inverse relationship
The demise of the Bretton system was inherently a liquidity problem. As the growth of international trade outpaced that of US gold mining activities, the demand for international reserves (US dollars) outpaced US gold reserves. In essence, gold was not mined fast enough, making it a scarce resource – and so its true value exceeded US$35 per ounce. Effectively, the failure of Bretton Woods was a simple supply-and-demand problem, where the demand for US reserves (or, crudely, gold) was far greater than its supply, leading to what should have been, a higher price of gold.
History tells us that, in general, there is an inverse relationship with the US dollar and gold. As the dollar strengthens, the price of gold falls, and vice versa. In the example above, it was effectively a weakening dollar (which at the time was overvalued) that should have raised the price of gold.
Moving forward into the 21st century, a boom in commodities such as oil and iron led to an increase in prices including those of precious metals such as gold. Despite the sharp slump coinciding with the financial crisis of 2007, metals in particular witnessed high price increases in the subsequent years.
Gold hit an all-time price high in September 2011 (more than US$1,900 an ounce, and silver was priced at US$49 an ounce in April 2011. While platinum peaked in March 2008, in May 2011 it was priced at just under US$1,880 an ounce, a five-year high. The falling prices we are now seeing in gold and other metals too has some speculating this is the end of the commodity bubble – though this certainly a very pessimistic take on the matter.
Light at the end of the tunnel
Ever the optimist, I would like to think that the falling prices in commodities (including gold) is because we are beginning to see light at the end of tunnel of what has been the largest financial crisis since the Great Depression. It is a well-known fact that when the financial system collapses and the economy becomes increasingly turbulent the demand for commodities, including gold rises. Look no further than the Bolivian hyperinflation where tin-ore became the commodity of choice (and when needed was exchanged for US dollars) to tackle a peso that was losing value by the hour. With short-term interest rates cut close to zero and quantitative easing reducing longer-term rates, present-day investors have avoided losing out on interest payments by holding gold.
But, with a mooted rise in interest rates in the near future and signs of economic recovery in spite of the eurozone crisis, it is inevitable that investors are looking to substitute back from commodities to other financial instruments. With interest rates unmoved at present, it could be that investors are pulling out while the price is high, which is contributing to the current falling price of gold. The data further shows that the US dollar is gaining strength vis-à-vis the euro and if interest rates do rise, then this may continue. Again this links back to the inverse relationship between the US dollar and the price of gold.
Will the price of gold keep falling in the future? While this is a possibility, I would exercise extreme caution. The economic recovery in the US has been uneven at best, so more swings are possible – and other forces should not be ignored. Although the current cracks in the eurozone have been papered over, the longer-term problems associated with the region are far from resolved.
Not only that, but with the demand for commodities (gold included) likely to increase in emerging markets when their economies recover, there is every possibility gold prices may start to rise again. Whereas most of the above has focused on the demand for gold, ultimately the mines that supply this resource will also have an important role to play.
The Chinese stock markets have experienced significant turmoil in recent weeks, with the Shanghai Composite Index – the country’s major reference – falling by 32% since June 12. But this fall was preceded by an equally sharp rise of 150% over the previous nine months. In the 20 years since I have been working in finance, I’ve never seen anything like this. So what is going on with the Chinese stock market?
There are several reasons for this unusual behaviour: firstly, when I teach stock market investment to my Chinese students, I always remind them that the Shanghai stock exchange should be thought of more as a casino, rather than as a proper stock market. In normal stock markets, share prices are – or, at least, should be – linked to the economic performance of the underlying companies. Not so in China, where the popularity of the stock market directly correlated with the fall in casino popularity.
Stocks and casinos
In China, given the low credibility of the financial statements published by listed companies, investors need to rely on other tools to predict share price performance. These tools include a heavy reliance on technical analysis and charts – a method that tends to predict future share price based purely on the company’s past performance, with no regards to its fundamentals. Even the name of the company is often neglected; all that matters is the historic price performance.
While this technique is also used in Western markets, my experience in China is that it is the predominant method for investment. Hence the disconnect between a share’s price movements and economic fundamentals.
There has been, however, a strong correlation between the stock market’s performance and the revenues of the casinos in Macau. While gambling revenues were growing at a fast pace in Macau, people largely ignored the stock market – whose performance was, largely, uninteresting for a number of years. But since China’s president, Xi Jinping, launched a campaign against corruption, gambling activity has started to decline. This was when the stock market started to move up. Coincidence?
The other reason why the stock market experienced a sharp increase between September 2014 and June 2015 relates to the Chinese real estate market. In recent years, investment in real estate has been the only way for ordinary citizens to get returns higher than the paltry 3% offered by bank deposits (yes, 3% is paltry in an economy that grows at more than 10% a year in nominal terms). But high capital requirements and growing regulations on the purchase of real estate has meant that benefiting from this growing market has been increasingly difficult for ordinary citizens.
Commercial banks therefore – in an effort to mimic real-estate returns – started to offer so-called “wealth management products”, which are basically funds that invest in the real estate market. These funds were then repackaged and resold in the retail market. Chinese individuals would take their savings out of current accounts and placed them into these wealth management products and achieve returns similar to those available to buyers of real estate.
This was the modus operandi until the beginning of 2014, at which point the economy and the real estate markets started to show signs of weakness. The once-easy money coming from the property market started to disappear and people with wealth management products started to get into financial trouble and some of them even defaulted on their payments (the government bailed them out, so no individual was at a loss).
From November 2014 the Chinese central bank, worried about the slowing economy, decided to institute an aggressive monetary policy to rapidly lower interest rates with the aim of stimulating the economy, which also caused current account rates to decline. This created a perverse scenario where individuals who were already seeking returns higher than those offered by current accounts were then denied the opportunity to get them through real estate because of the falling market. As a result, deposit rates were cut further and the return on current accounts became even more dissatisfying. Commercial banks found themselves in a quandary.
With the casino route closed and real estate off the table, what was left? The Shanghai and Shenzhen stock markets: the two main stock markets that had remained dormant for years.
Banks then turned the old real estate wealth management products into investment vehicles to purchase shares directly on the stock markets. A large portion of customer deposits were then directly invested in the stock market, which then surged on the back of that demand.
An empty bubble?
Meanwhile, however, nothing happened to the earnings forecasts of the underlying companies. In fact, if anything, they should have been revised down because of the deteriorating macroeconomic condition of the Chinese domestic economy. But of course, as we said before, no one really looks at earnings and price ratios.
Due to the desire to maximise returns, many individuals then used leverage so that the inflow of money in the stock market was even higher. For example, if someone wishes to purchase shares for a total value of 100RMB, but only has available cash in his deposit account of, say, 60RMB, he could borrow the remaining 40RMB from the brokerage house. By doing this, the original source of 60RMB was turned into an upward push of the stock price equivalent to the full 100RMB. This drove strong share price growth between September 2014 and June 12 2015.
What happened on June 12 2015? Nothing. Just some smarter investors (generally large institutional investors, which represent 20% of all market volumes) started to sell and the rest of the market followed suit. Fear got hold of small investors (who represent 80% of the market) and selling accelerated, with margin calls making those selling do so even faster, and here we are today – a 32% drop and counting since the peak of mid-June.
In the past few days, the Chinese government has adopted a number of measures to try to mitigate this crash. The market finally reacted positively to a relaxation of restrictions on margin requirements. But this measure simply transfers the risks from investors to brokerage houses – it does not change the fact that the market has increased by 70% over the last year. The bubble, if it is a bubble, still has a long way to go.