Tim Bond of Barclays has been remarkably accurate in predicting the strength and length of the global equity rally. Despite the many signs of weakness over the last 9 months Bond has remained very optimistic (read his bullish note from 2009 here). He claimed that analyst estimates and high levels of bearishness would lay the foundation for a continuing equity rally.
“Never has a bull market climbed a steeper wall of worry. Despite a proliferation of positive economic indicators, the consensus remains resolutely gloomy. Bullish economists are still rarer than hens’ teeth. The average forecast for Q3 US GDP growth is an anaemic 0.8% increase, which would be by far the slowest first quarter of any recovery on record.”
He couldn’t have been much more accurate. The economic landscape is quickly changing, however, and Bond’s outlook is turning decidedly less optimistic. Bond now believes the problem of debt is becoming contagious in Europe and that higher bond yields will accompany the process:
“Fiscal dynamics point towards higher government bond yields in many economies, including the UK and US. History is unequivocal in linking fiscal deterioration to higher yields. This point is clearly becoming recognized by investors. As a result, a contagious process has started, during which risk premia in bonds, equities and currencies adjust higher to reflect the fiscal situation. This process is unlikely to remain confined to southern Europe, but will eventually embrace all those economies with sizeable budget deficits.”
Bond has argued for much of the last year that low rates and de-leveraging were actually very bullish for equities. As monetary policy begins to shift and fiscal policy remains imprudent the landscape is shifting. Like Teun Draaisma, Bond is concerned about the impending higher rate environment that will accompany global rate increases and continuing risks associated with an indebted global economy. Bond argues the long-term situation remains unfavorable for 3 primary reasons:
1) The majority of the G20 is a fiscal mess
2) Demographic trends of the G20 are highly negative
3) Containing the long-term government debt problem will be painful
Most alarming to Bond, however, is the close relationship between high debt levels and rising rates. In studying 6 developed nations over the last 20-30 years, Bond found that a 1% change in deficit/GDP caused a 32 bps increase in 10 year rates. Based on this, Bond says we are due for a substantial rise in global rates. This “abruptly” deteriorates the outlook for equities:
“The analysis also reinforces our standing recommendation to ratchet down equity risk in the current quarter, in expectation of corrective behavior in Q2 and Q3. The timeline we had in mind is being accelerated and a contagious process is already underway. To be sure, such an approach might be overly cautious and premature. There is an obvious risk of missing out on further gains from the liquidity fueled portion of the bull run. Some investors will undoubtedly wish to continue dancing on the edge of the volcano and we wish them good luck.”
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.
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