The British vote on whether to retain its European Union membership of over forty-years standing dominated the business news during the year’s first half, and fears that the “Leave” camp could win the contest unsettled financial markets in the run-up to the referendum in late June. They were not unsettled enough, apparently, to “price in” the eventual outcome, and two days of selling promptly followed the “Brexit” vote, leading to losses of about 5%, or $3 trillion of equity market value. The British currency lost a record 10% in one day, dropping to levels not seen in over 30 years. Regaining some of its “haven” status, gold rose to two-year highs, and even silver perked up after a long period of lethargy.
Beyond stock market upheavals and renewed speculation in precious metals, repercussions of the British decision were felt word-wide. In Britain itself, certain real estate investment funds were forced to freeze investor redemptions due to the depletion of cash reserves, moves reminiscent of ones that took place during the financial crisis of 2008-2009. But the primary transmission mechanism for economic and political worries was the bond markets. As neatly illustrated in the graph on this page, which shows the historical yield pattern of the 30-year U.S. treasury bond, the rush to safe havens has reinforced a 35-year trend of ever-lower bond yields. The yield on the 30-year reached a record low after the Brexit vote, as did that for the 10-year treasury note. The latter security is important as a benchmark for determining the rates on other financial instruments—U.S. mortgages, for example.
Developments in the bond market during the last year have been truly extraordinary. Even before Brexit about $10 trillion of sovereign debt, issued mostly by European countries, but also Japan, yielded buyers a negative return. Instead of stuffing cash in mattresses, buyers paid governments to look after it. That figure has expanded to roughly $12 trillion. The entire debt stock of Switzerland now offers negative returns, including that for a 50-year bond. Issuers from the U.S. to Australia are paying record low rates on their debt. Ireland and Belgium have sold 100-year maturity debt yielding just 2.3%. Slowing growth in the world economy, excess liquidity, central bank stimulus policies, and safe-haven buying have produced, by some measures, the lowest rates in hundreds of years—even thousands, according to one Bank of England report. As one observer quipped, instead of “risk-free return” (referring to the credit-risk status of the highest grade sovereign bonds), we now have “return-free risk.”
We believe that when the financial history of this period is written, the dominant theme will be this relentless decline in interest rates. Its impact has been felt everywhere in the financial realm, from the housing market to hedge funds. Even the roots of the financial crisis can be laid at its doorstep; the “reaching for yield” behavior of market participants in an era of low rates created a demand for the types of exotic products that almost wrecked the banking sector. Even now a new reach for yield—any yield in this case—is, in our view, storing up trouble for the future. Any security that offers a decent-looking yield in the current environment of negative returns for low risk will almost certainly require a far higher rate to entice buyers when conditions return to normalcy. Higher yields imply lower market prices—perhaps, much lower—than those prevailing currently.
How all of this plays out in the future will be a matter for the historians, but in the here and now, those of us with responsibility for investing other people’s money are forced to “speculate” on possible outcomes and weigh risks. In this situation we are reminded of another period, the late 1890s, which was also characterized by a long trend involving an important facet of finance. In that case the U.S. had known about 25 years of deflation (falling prices). A survey of economists at the time revealed that virtually all of them expected the deflationary trend to continue. As it so happened, shortly thereafter, a period of rising prices began that continued for about thirty years.
During the last thirty-plus years, the world has experienced disinflation, with the prices for goods continuing to rise, but at a decreasing rate. Since bonds are sensitive to inflation, their prices have responded as shown in the graph, with falling yields (and rising prices) as inflation “expectations” fell over time. The result has been that an entire generation of investment professionals, and a large part of the investing public, has known only a world of declining interest rates. Those who entered careers on Wall Street during the last decade have experienced very low rates, and now negative ones. Millions more have taken out mortgages at 4% or less (6% used to be the norm). Furthermore, you don’t have to go back a century to find a long-term trend reversal in the financial markets; interest rates have been falling for 35years, but before that were 30 years of rising interest costs and falling bond prices. We wonder how the current Wall Street establishment and the public will react to an unexpected change in the current, well-established trend. We are skeptical about the eventual outcome. Buying a 50-year bond with a negative return requires either a great deal of faith in one’s ability to predict the future, or a belief in the greater fool theory—probably both. We confess to possessing neither.
When Will They Ever Learn?
So far in 2016 we have experienced two episodes of stock market swoons. In the year’s opening months, fears surrounding the implications of the oil price collapse induced a sell-off and declines in the 10-12% range. Recovering energy prices led the equity markets higher as well, and stocks were roughly flat by the end of the first quarter. The Brexit-induced fall in late June reached 5-6%, but waning fears over the consequences of having a European Union without the UK ended the stock market rout, and indexes had returned to about pre-Brexit levels by June 30.
As we contemplate these episodes of market turmoil, and the many others that have occurred since the early 1980s when our personal experience with the markets began, we are struck by how little is learned from these events. The same patterns repeat themselves time and again—panic, selling, and depressed prices, followed by a return to calmer conditions, but with higher prices for securities that are now owned by someone else (an interesting aside: in the aftermath of the panic selling during the collapse of the early 1930s, stock ownership in the U.S. actually broadened; someone was buying what the investment trusts were selling). Many on Wall Street and in the business media speak of the markets in anthropomorphic terms, as if markets can weigh, judge, and act in an understandable fashion. They really can’t. Markets represent a seething mass of ever-changing participants. Individual operators may learn from experience and act accordingly. In the aggregate, however, markets “learn” nothing.
Market participants as a whole are incapable of looking beyond the short-term fears that possess them in a moment of panic. In a way this is understandable. When one looks at a long-term chart of a stock market index, it is positively sloped—prices have risen over the long run; in a long enough time range, even the 1929 crash is a small “blip” on the graph. However, each little downward move indicated on the chart represents falling prices, and to someone living through the event, that can be a frightening experience. One never knows for certain whether the historical pattern will resume its nice upward slope going forward, or whether price weakness is the beginning of something more serious and long lasting. So far, at least, markets have always recovered from downdraughts and marched higher over time.
Markets’ inability to learn means their behavior at times of stress is not likely to change much. Panics of varying magnitude will always occur from time to time, as will extremes of enthusiasm. As investors, we seek to look far ahead, understanding that the upwardly sloping chart means short-term concerns are usually overblown, and that conditions will recover in time. We welcome markets’ arational behavior as it creates opportunities for us. At all times we keep in mind, however, that prices may not recover quickly, and that long drawn-out periods of frustration are possible. The traditional definition of investment has always emphasized the need for long-term thinking.
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Stock index charts remain positively sloped as prices recovered from each of this year’s pullbacks. Year-to-date returns at June 30 came in at 3-4% for the Dow and S&P 500 indexes—not too bad, all things considered. Gold regained its “haven” status according to the commentary, presumably in response to political events and economic uncertainty. Oil retained most of the price gains since bottoming at $27 earlier this year. Believing as we do that most market behavior is meaningless, we do not read anything into these short-term results, and do not see them as foreshadowing future moves. As a market observer once said, “through all things we make our way.”
Dennis Butler, MBA, CFA