Panopanic 2018
Whilst you can make some strong arguments for the negative returns from 90% of asset classes in 2018 based on the return of populist politics – think of Brexit, Italy’s political instability, AMLO’s election in Mexico and tariffs everywhere – the answer to those negative returns might be simpler: the de facto global discount rate, the 2-year US Treasury bond yield, has risen by almost 100 basis points (bps) over the year, and thus repriced global assets. Why did this happen?
Well, 2018 was the year in which the global Quantitative Easing (QE) experiment started to come to an end. In the wake of the Global Financial Crisis (GFC) in 2008 and the aftershock of the subsequent Eurozone Debt Crisis, central banks around the world started buying their own government bonds on a massive scale. The effectiveness of such programmes has been widely discussed, but most academic literature agrees that buying sovereign bonds brought down yields, creating a “portfolio rebalancing” effect that led investors to reach into riskier assets for income. In the UK, gilt investors sold their government bonds to the Bank of England and bought high quality corporate bonds instead; credit fund managers similarly added high yield bonds to their portfolios, while high yield investors moved down from BB to B rated debt. This led to a global inflation in asset prices, with the price of everything, from equities to art and fine wine, going up. The owners of such assets tended to be already wealthy, so inequality in society increased. Central banks regarded this as a known and necessary side effect, since inflation and economic growth also rose due to lower financing and debt servicing costs, benefiting everybody – but some argue that QE was a factor in the rise of political instability.
If you believe all this to be true, then you must also believe that when QE is reversed and becomes Quantitative Tightening (QT), then those portfolio effects should also turn. This year, we have already seen sovereign bond yields around the world starting to rise, helping risk-averse investors achieve their income targets without taking so much credit risk. This has led to the “yield tourists” in higher yielding asset classes starting to move back up the quality curve, pushing risk premia upwards, lifting borrowing costs and dragging down the price of risky assets.
So far, QT has mainly been a feature of US monetary policy and the Federal Reserve’s balance sheet: the central bank’s holdings of US government bonds, mortgage-backed securities and other assets is expected to shrink to around $3 trillion in two years’ time, from a peak of over $4 trillion between 2015 and 2017. Whilst the Fed is not actively selling bonds, the absence of its market presence as an ongoing bond buyer is highly relevant, especially at a time when supply is only set to increase. US President Trump’s tax cuts and the ongoing increases in fiscal burdens caused by an ageing population mean that we will see budget deficits of well over $1 trillion per year for the foreseeable future. So, more bonds are coming to market, but the biggest buyer has gone.
...MUCH MORE
