In 1994, I was involved in introducing an updated version of the “traditional” balanced product to the European institutional marketplace. Balanced products were typically made up of a mix of 50 per cent local equity and 50 per cent local bonds.
Our suggestion at the time was that European clients should move to a mix of pan-European equities and global bonds. The biggest point of contention was not around the proposed asset mix but around the global bond benchmark, which included a significant exposure to JGBs¹. At a 2.5 per cent yield for 10-year maturities, clients felt that including JGBs in the benchmark would make it too easy for us to outperform by shorting JGBs. Consequently, they argued that JGBs should be excluded from the benchmark. The rest is history: 10-year JGBs today are yielding a hard-to-believe 0.59 per cent.
Twenty years on — with 10-year German bund yields falling back to a level of 1.35 per cent and US 10-year Treasuries falling to 2.51 per cent — retracing more than half of the “taper tantrum” correction of 2013, we are faced with similar questions: Will the global economic recovery gather pace? Will the massive liquidity support by global central banks and improving employment conditions in most economies finally lift inflation expectations and inflation itself? Or are we on a Japanese-style disinflation trajectory?
It would seem as if equity and bond market participants disagree with one another, with equity markets continuing their upward move, albeit more moderately, to reach multi-year highs, while bond yields are retracing their historic lows — with even emerging market debt rallying in recent months.
While there are certain parallels between Japan in the 1990s and today — including demographics and deteriorating public finances, particularly in the euro zone — the differences between Japan then and the rest of the world today are more meaningful. For example, central banks became more accommodative more quickly, the financial sector in the OECD² was cleaned up more rapidly, fiscal policy in the whole has been more pro-cyclical and, importantly, there is greater awareness of the risks of deflation.
Consequently, we continue to view the low yields observed on most all fixed-income securities more as a function of the dynamics of financial repression than the market’s fear of deflation, and we would suggest that a repeat of the Japanese experience is unlikely within the current policy framework. Investing in the long end of the OECD bond markets will likely produce negative yields, so the only alternative continues to be to take on risk in a smart way.
Source for yields: Bloomberg as at 20 May 2014.