Between a Rock and a Hard Place

In recent years, investors have crowded into predictable equities that look like bonds, be they defensive companies with stable cash flows or strong growth companies acting as long duration zero-coupon bonds. As bond yields fall, the logic goes that lower discount rates lead to higher equity valuations. While that strategy has worked this far, we would be very wary of its future outcomes.

COVID-19 has had a significant impact on economies and hence markets. US 10-year bond yields have fallen below 1%^[1], which is the lowest nominal yield since 1871 (the earliest period for which data is available^[2]). This phenomenon is not confined to the US, with 10-year bond yields in Canada, UK and Australia also below 1%, and negative in France, Germany, Japan and Switzerland. While they have fallen to a record low of 2.5% in China.^[3]

With such low yields, the idea of nominal bond yields moving higher over the medium to longer term^[4] and/or the risk of negative real returns (i.e. after inflation) from bonds over a similar timeframe, is hard to argue against.

However, those who adhere to the alternate view that bond yields will remain low for this timeframe and that this will be good for equities, have perhaps not observed Japan in recent years, where a prolonged period of very low interest rates has had poor consequences for passive equity market investors.^[5]

While rising bond yields does not mean high bond yields^[6], we conclude that at this juncture, we are between a rock and a hard place for bonds and hence for equities that look like bonds.

A more comprehensive analysis of bond and equity market returns over the very long term is provided as appendices in the unabridged article for those interested in the background to, and history behind, the assertions above. However, in simple terms, our key observations are:

1. US 10-year bond yields have moved in very long cycles, whereby multi-decade peaks (troughs) in bond yields have coincided with troughs (peaks) in equity markets. Today, we have all-time low bond yields and close to all-time highs for the US equity market^[7] after a near 40-year fall in yields.

2. When we see negative real returns from bonds, the outlook for real returns from equities tends to be unfavourable. With nominal yields so low today, it will only take minor falls in bond prices or small amounts of inflation to turn positive real returns to negative real returns over the coming decade.

3. If you disagree that the above scenarios are plausible, we can look to Japan as an example of the impact of persistently low nominal rates. This has not been a boon for equities. Since 10-year Japanese government bond yields reached 2% in October 1997, the equity market total return has been an anaemic 1.8% p.a.^[8] While many cite high levels of debt or poor demographics for the reason behind this, interestingly, the rest of the world has these same features today. Persistently low bond yields are likely a sign of deeper problems that will ultimately plague equity returns, especially when starting valuations are high.

Taking into consideration the above observations, our flagship global equities portfolio, the Platinum International Fund, is currently tilted towards companies that may benefit from fiscal spending replacing monetary policy as a key driver of growth. We are also carrying short positions in expensive markets, specifically, stocks that may have been treated in the bond proxy category as defined above.

The full article can be viewed here.

^[1] 0.70% at the close on 26 May 2020. Source: FactSet.
^[2] Source: http://www.econ.yale.edu/~shiller/data.htm
^[3] As at 26 May 2020. Source: FactSet
^[4] Ahead of the COVID-19 outbreak, Platinum’s CIO, Andrew Clifford, outlined reasons why he believes interest rates are no longer a one-way bet: https://www.platinum.com.au/Insights-Tools/The-Journal/Macro-Overview-December-2019
^[5] Refer to our article Stock-Picking amid Chronic Low Rates - Lessons from Japan, by Platinum portfolio manager, Clay Smolinski, where he explains that investing in Japan has been a great market for active stock pickers.
^[6] https://www.platinum.com.au/Insights-Tools/The-Journal/Interest-rates-to-be-lower-for-much-longer
^[7] Encompassing all major US market indices including the S&P 500, Russell 2000, NASDAQ Composite and DJ 30 Industrial Average.
^[8] TOPIX total return in Japanese yen from the market high on 20 October 1997 to 31 March 2020. Source: FactSet.


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