Dangerous overvaluations, the return of inflation and a shift in the supply/demand behind interest rates all mean bonds and ‘bond proxy’ equities will have a very volatile 2016 and beyond, according to FE Alpha Manager Rob Burnett, who runs the Neptune European Opportunities fund. 
Concerns surrounding the outlook for bonds have ramped up over recent months, especially given the US Federal Reserve raised interest rates for the first time since 2006 earlier this week.
Nevertheless, for all the bearish commentary surrounding fixed income, the widely prophesied bond market collapse has yet to occur and many believe that the negativity surrounding the asset has been far too overdone thanks to signs of slowing growth in parts of the world, high levels of debt in the system, very low inflation and continued over-capacity in the global economy.
Burnett, though, says investors are hugely naïve to think fixed income offers any sort of value on a long-term view.
In fact, the manager – whose fund sits comfortably in the IA Europe ex UK sector’s top quartile and is well ahead of its benchmark since he took charge in May 2005 – says it is an asset class that has the propensity to lose investors a lot of money of the coming year and beyond.
Performance of fund versus sector and index under Burnett
Source: FE Analytics
“I’m not too worried about the politics for now, emerging markets or the economic outlook, this is the thing that is stressing me out,” Burnett (pictured) said. “I know we are an equity house, but we really think and I genuinely believe that this is the time to start being structurally cautious on bonds.”
While he admits many may disagree with his view, here he highlights why he is so negative on bond markets and (by extension) defensive equities such as consumer goods, tobacco and healthcare stocks.
They are dangerously overvalued
The first reason, according to Burnett, is because the bond market is ‘dangerously’ overvalued.
To illustrate this, he collected the data looking at the German bund market’s P/E (which is used is 1 divided by the dividend yield) since 1807.
“Bottom line, the German 10 year bund P/E – a measure of value – got to 1,000 this year. There has never been a precedent for this level of overvaluation. Yields have gone up a bit since then and the P/E is now about times, but it is still incredibly high,” Burnett said.
“My worry next year, and my prediction, is that we will see significant volatility in bond markets and especially in the highest quality assets.”
“Bizarrely, the riskiest assets today are the highest quality sovereign bonds as they are the most overpriced.”
Source: Neptune
Obviously, Burnett works for an equity-only house so his views may be taken with a pinch of salt by many investors.
However, he says this affects him as an equity investor because since bond yields started to fall dramatically during the credit boom and as a result of ultra-low interest rates and quantitative easing since the global financial crisis, certain parts of the stock market have been boosted.
This is because ‘tourist’ fixed income investors have been forced out of the bond market in search of higher yields, but as they have wanted dependable dividends, their hunting ground has been among high quality companies with reliable earnings such as those in the consumer staples and healthcare companies.
This has driven their valuation higher and higher, but Burnett says their fortunes are now closely correlated to bonds.
Performance of indices since December 1998
Source: FE Analytics
Burnett added: “It matters to me because there are a lot of equities which are ‘bond proxies’ that have done well as bonds have rallied. If I think this is a multi-year turning point in bonds, this will be a multi-year turning point for bond proxy equities – those defensive, very cautiously positioned equities.”
Inflation is coming back
The second reason why Burnett is worried about bonds and bond proxies is because of the early stage signs that inflation is returning to the world economy.
Of course, many have seen very little evidence of this as the huge collapse in the oil price over the past year-and-a-half has pushed CPIs around the world to very low levels – and even negative in certain regions.
On top of that, many warn that China’s slowing growth will be a major deflationary force which markets will have to deal with.
Burnett disagrees with this consensual view, however, and warns that improvements at a consumer level will drive inflation higher in the developed world which, in turn, will erode the real value of bonds over time.
“Inflation could be coming back. We all think it has disappeared for life. It hasn’t, this big collapse in the oil price over the last year or so is masking, shielding and hiding a brewing pick-up in inflation.”
Performance of indices since January 2014
Source: FE Analytics
“Wages are rising. They are rising here in the UK, they are rising in Germany and they are rising in the US. The seeds of inflation are beginning to be sown – not out of control inflation, but inflation that is higher than expected.”
He added: “That is another element which will lift yields next year and cause bond market volatility.”
Baby boomers will stop saving and start spending
The final reason to be bearish on bonds, according to Burnett, is more of a longer term theme than the two previous concerns mentioned.
“Interest rates are a price, they are set by supply and demand. What is the supply on interest rates? It’s actually savings. The more money that is saved globally can be lent and so the supply of credit worldwide is a function of how many savings there are in the world.”
“In the last two decades, because the baby boomers have saved so much money and because of the emerging markets entering the world economy, we have seen this massive growth in savings. The global pool of savings has grown hugely relative to global investment (the demand side of interest rates).”
“The supply side of interest rates has been huge versus demand and that has pushed rates down on a secular basis and pushed sovereign bond yields down and down and down since 1980. This is irrespective of inflation or growth, this is a big effect that has been pushing up bond prices.”
Source: Neptune
However, Burnett says this dynamic is about to change. He says that as the ‘baby boomer’ generation hits retirement, the pool of global savings relative to investment will peak.
“When you retire, you stop saving, you start drawing down and start spending,” he said.
“As this happens, the supply side of interest rate falls and therefore with demand relatively stable, the price of interest will go up. It is a big idea and you can’t predict this overt the short-term, but it is something to think about over the next decade.”
“If we are right, then the trend of interest rates is upwards not downwards. Again, irrespective of growth or inflation, interest rates could surprise higher than people are expecting and obviously, this is bad for bonds and this bad for bond proxies.”
To counteract these risks, Burnett is running a more economically sensitive portfolio in his £485m Neptune European Opportunities fund than many of his peers. For example, he is overweight banks and has greater exposure to peripheral European markets such as Italy than most other managers in the sector.
