I will admit I am deeply worried about the implications of negative interest rates.
In late July, the US Federal Reserve (Fed) cut rates a quarter-point. This didn’t seem to appease investors who dumped riskier assets for the safety of government debt and drove down yields even further.
The 30-year US Treasury bond in August fell below 2 per cent for the first time, while the 30-year gilt also set a record, slipping below 1 per cent. The two-year to 10-year Treasuries yield curve inverted, historically an indicator of recession, albeit an imprecise one.
The scale and speed of the lurch downward in yields has been absolutely phenomenal. It took two years for rates to grind upwards to double from their 2016 lows, and it has taken less than a year for them to go right back down again.
It is frankly terrifying that there is as much as $17trn worth of negative-yielding debt – government bonds as well as corporates – in issue. The whole of the German yield curve is negative, and I may not be alone in worrying that US could be heading in a similar direction.
I am concerned about the persistency of bond yields at the moment. In conventional economic theory, savers need a rate of interest to defer current consumption to the future. We need a positive interest rate to guide capital allocation and price discovery in financial markets. In this environment, you can discount a company’s future earnings by nothing and end up with a firm that is valued at infinity. Check the We Work prospectus for details!
This move in the bond market continues to stretch the gap between growth and value stocks further to almost absurd levels. The Merian UK Alpha fund is both beneficiary and victim of this trend. Our growth stocks are doing well and multiples are expanding, and our value stocks continue to underperform.
The recent corporate results season also showed the rate environment creating considerable margin pressure for banks. No surprise there. How is it possible that a Danish bank can offer a negative-rate mortgage – allowing homeowners to pay back less than they borrowed over 10 years?
To be sure, there are economic risks. The recovery is ageing, China-US trade war looks far from resolution, inflation is conspicuously below target after years of central bank stimulus and dollar strength is pressuring some emerging markets.
And yet – I wonder if the bond market may be over-reacting.
The yield curve has inverted, yet other recession indicators you might expect to see are conspicuously absent. Investment-grade and high-yield corporate credit markets are not showing the same stress levels of last year.
The consumer and services sectors of the economy remain fairly robust. Low rates in the US are boosting the housing market as consumers refinance and take out loans for home purchases. Here in the UK, wage growth is 3.9 per cent, the labour market is strong and consumer demand is holding up.
Manufacturing is weak globally but also is suffering from specific weakness in the car market related to electrification and the temporary impact of the Boeing 737 production cuts in the US aerospace industry. We had manufacturing downturns in 2013 and 2016 that didn’t trigger economic recessions. There has been an ebb and flow in factory output throughout this 10-year economic expansion.
It is worth noting that governments including Germany (yes, Germany!), China and the US are talking about fiscal support for their economies. Expect to hear more about infrastructure spending ahead of the US election. Here in Britain, the new prime minister is on what appears to be a pre-election campaign and is promising money left, right and centre.
I worry about what is going on in the bond market but I am much less concerned about the real economy. It is possible that a combination of further economic growth, an uptick in government spending and some Fed easing could calm the bond market and deliver a more normal rate environment. In six months, we could be in a very different place.
I certainly hope so.
Richard Buxton is head of UK equities at Merian Global Investors. The views expressed above are his own and should not be taken as investment advice.