- The total amount of negative yielding bonds surpasses $16 trillion… Could negative debt be the new subprime?
- Insider selling rises to its highest level since before the global financial crisis, while the pace of corporate buybacks slows.
- Equity markets dipped in August but rebounded on upbeat trade news. Bonds post historically strong returns as yield continue to fall.
- Money is flowing out of equity funds and into bond funds at an increasing pace.
What Piqued Our Interest
We truly are in unchartered waters regarding the current state of the global debt market. Let us mince no words here… the amount of negative yielding debt across the globe is staggering. According to data provided by the Financial Times and Bloomberg, the amount of sub-zero debt recently surpassed $16 trillion, which is about one third of the total global bond market! This leads us to ponder, are we in the midst of the next major asset bubble, similar to subprime debt and internet stocks of past crises? What would it take for this run on bonds to dramatically reverse itself? For one, expectations for growth would have to significantly increase while deflationary concerns abate, and that might require massive synchronized fiscal accommodation, as the U.S. Fed is the only major central bank with room (albeit slight) to meaningfully lower interest rates. With economic growth slowing across the globe, and continued uncertainty from the U.S.-China trade war, it continues to feel like this will get worse before it gets better. We believe this spike in bonds reflects investors’ recessionary fears and urgency to shed risky assets and seek safety within government bonds at any cost.
Looking closer at the 10-year government yields of developed nations, we note that the vast majority of European countries, along with Japan, all have negative yielding debt. A rational person might wonder why an individual would “pay” the government for the right to hold their bonds, but the reason is generally that they expect yields to fall further pushing prices even higher. On average, the bonds yield 1.36% less than the yield of the 10-year U.S. treasury, which is clearly one of the major factors driving our rates lower. Switzerland currently has the lowest yield around -1.05% (as of 8/28/19), while German 10-year bonds keeps falling and are now at -0.72%, as both countries have negative yields going all the way out to 30 years. Many investors now fear that long struggle against deflation and feeble growth despite massive monetary stimulus. Contributing to this viewpoint, former U.S. Treasury Secretary and Harvard economist Larry Summers tweeted on August 22, “Black hole monetary economics – interest rates stuck at zero with no real prospect of escape – is now the confident market expectation in Europe & Japan, with essentially zero or negative yields over a generation. The United States is only one recession away from joining them.” While this opinion may be somewhat sensational, the potential reality is nonetheless sobering.
In that regard, prospects for a near term recession in the U.S. still remain fairly low, despite the calamity being predicted by bond market. The Conference Board’s Leading Economic Index increased by 0.5% in July, suggesting moderate growth for the second half of 2019. Supporting the recent increase were improvements in housing permits, unemployment, and credit expansion. In addition, the consumer confidence index remains high, along with the Small Business Optimism Index. 2nd Quarter GDP was revised marginally lower from 2.1% to 2.0%, however personal consumption was revised higher to a 4.7% increase, its largest gain in five years. Considering that consumer expenditures make up almost 70% of the U.S. economy, this trend certainly bodes positively. On the flip side, manufacturing continues to drag on the global economy, particularly overseas. While the Purchasing Manager’s Index is still in positive territory in the U.S. at 51.2 (above 50 implies expansion), Japan, China, and greater-Europe are all reporting solidly negative readings.
Equities tumbled during the beginning of August, falling by roughly 6% from late July before finding pockets of support and eventually ending the month stronger. Overall, the S&P 500 fell by -1.58%, while Small Caps fared much worse and declined almost -5%. The strongest sectors in August were defensive dividend paying sectors such as Utilities (+5.16%), Real Estate (+4.87%), and Consumer Staples (+1.8%), while Energy stocks dropped furthest (-8.07%) followed by Financials (-4.85%.). Even though defensive stocks fared well during the turbulent month, “Value” stocks overall fell more than “Growth” as negative rates and the inverted yield curve has taken a toll on financials while energy has been impacted by slowing global demand. Tech stocks sold off the most during the first half of the month but rallied based upon trade-deal optimism and finished -1.5%, roughly in-line with the broad market. Internationally, developed countries continued to outperform emerging, as the EAFE index fell by -2.59% compared to -4.88% for the EM index.
The big story for the markets in August continues to be the rapid decline in rates, highlighted by the U.S. 10-year treasury which dropped from a 1.89% yield to just 1.5% by the end of the month. As the 10-year bond yielded 2.68% at the start of the year, the overall decline this year has been quite significant to say the least. The drop in yields of course were driven by another bond rally, as the U.S. Aggregate Bond index gained another 2.59% in August, and is now up 9.1% year-to-date, far surpassing almost all expectations. Bloomberg news reported that investment grade corporate bond returns were up by roughly 3.3%, marking the best August return for the sector since 1982.
As volatility spiked and credit fears rose, the spread on high-yield bonds surged in August from roughly 4.4% to 4.8%, which limited the gain on high-yield bonds to just 0.4%, notably trailing the investment-grade bond universe. Finally, municipal bonds also realized healthy gains as the index rose 1.58%. It should be noted that Munis continue to exhibit a positively sloped yield curve, and the yield on a 20-year AAA Muni yields approximately the same as a 20-year treasury (1.67%) even before tax considerations are made.
Money has been flowing out of equity and into fixed income funds at an increasing rate in 2019. Using data provided by Morningstar, we observed that net flows for open-end mutual funds have been negative for equities every month this year except January, while flows into both taxable and municipal bond funds have been positive each month. Like the surge in bond prices noted above, this trend is yet another indicator of investors flocking toward safety as a reaction to slowdown fears. Another disturbing trend which we also referenced in our last commentary, corporate buybacks continue to decline, and were recently at an 18-month low in the 2nd quarter. Taken together, these trends leave us somewhat concerned, as buybacks fueled by low interest rates and corporate tax cuts have often supported the bull market over the past 10 years, particularly during periods of retail outflows. Going forward, companies may be more likely to sit on cash and be more opportunistic in their share repurchase strategies, given the trade war uncertainties along with next year’s election. In addition, recent evidence has suggested that insider selling has increased lately. According to TrimTabs Investment Research as quoted by CNN, August is on track for over $10 billion of insider sales, which has only occurred in 2006 and 2007, prior to the global financial crisis.
Irrespective of buybacks or insider behavior, how the next few months play out will ultimately depend on the trade war and whether a resolution can be negotiated. In many regards, we believe that the best stimulus policy to reignite the economy would be to end the tariff war, despite the merits of putting China to task for their unfair and illegal practices. This has been the underlying source of uncertainty and volatility for the past year and a half, yet unfortunately we do not anticipate that it will end soon.
Common sense suggests that President Trump can withstand several more months of volatility to appease his hardline base until we get much closer to the 2020 election. However, if his approval rating slips further or if recession fears continue to mount, we would expect to see a trade deal much sooner than later. With the next batch of 15% tariffs on $125 billion of Chinese goods going into place on September 1st, along with a second batch on December 15th, Americans will soon be paying more for retail goods such as clothes, toys, electronics and more. This is reflected in the latest University of Michigan Consumer Sentiment reading, which fell to 89.8 in August, its lowest level since October 2016, and its steepest monthly drop since 2012. While the consistent threats of tariffs may be an effective tactic in dealing with China, the repercussions are clearly being felt at home as well.
With all of these concerns, it’s easy to forget that the U.S. equity market is still trading roughly 3% lower than its all-time high reached this July. The labor market remains incredibly strong, consumers are still spending, and second quarter corporate earnings mostly surpassed expectations. We believe staying invested in the market is the prudent course of action but recommend doing so with strategies designed to mitigate downside risk. Incorporating factors into your portfolio such as high quality, low volatility, and value will help dampen the effects if the trade war suddenly spirals out of control. The S&P 500 has gained approximately 300% since it bottomed out in March of 2009, so we could be due for a serious correction in the not-too-distant future. For now however, we will continue to monitor the trade negotiations and messaging from the Fed, while implementing our “participate and protect” strategy. All eyes will be on the President and his tweets… lets hope this trade war is resolved before we all pay the price.