The Ebbing Tide: is the financial system ready for STEADY positive rates?
The Ebbing Tide: is the financial system ready for STEADY positive rates?
disclaimer: This is not financial advice, your mileage may vary.
there is in my opinion a little misconception about how “resilient”, to further abuse a misunderstood word, Equity markets are. Especially if one, like me, “Pivoted” to bonds in the early stages.
Specifically, I want to introduce you to a frame of reference I use in my day job, i.e., checking equity indices against bond yields. This in Europe has very interesting outcomes. Data are sourced from Bloomberg unless otherwise stated, but they are widely available elsewhere for those who want to dabble with spreadsheets, which is all the expertise required to replicate my results. So, let's start.
People are making a big fuss now about inflation, but the truth is that apart from marketing reasons, asset managers should have very little interest in the subject matter per se. In fact not only all the income or profit is nominal, but inflation is the ultimate “Bed of Procustes”: each individual has his own “inflation”, depending on his income, wealth, spending preferences etc. Anyway governments now routinely issue inflation linked bonds to final savers.
What people don't seem to get is the connection between long bond rates and equity valuations. This is not a mechanical connection, but over longer time frames the connection is not only indeed there, but there are a number of considerations connected mainly with monetary policy which should be kept in mind.
At any point in time, a saver is faced basically with three alternatives: Cash, bonds and stocks.
The first is quite an overlooked part of the saver's arsenal (mainly because it doesn't generate fee income to the banking system), but it's not my main point here. The second and third, grosso modo, can be described this way: a bond investor has to have a good bead on his prospective return to maturity since entry point is the only defining variable. An equity investor doesn't, and moreover he intrinsically forecasts that at some point in the future, an equally rational investor will be inclined to bid for what he has bought at an higher price than what the saver has paid now for the same security.
Ok, but how much higher? That's where bond rates come in.
Imagine two guys at the gym, talking money. One (the equity guy) says to the other ”Hey, I bought this stock and I am sure to make 15% on that!”. At this point the other (the bond guy) promptly says “by when?”
The sense of the question is this: The first guy can be right 100% of the time, but that doesn't mean he gets richer than the second guy at all. Imagine that the second guy just bought at par a 6% bond expiring in three years: 6+6+6 = 18, which is higher than 15% which is the profit of the equity guy..
Now, imagine that the equity guy has a number of investment opportunities ordered by descending prospective return over three years: should he have a rule by which he won't put more than 2% in each, he would go on investing until he reached the one where he thinks he'll make 18.01%... and then he'll stop and buy bonds. No sense taking needless risk.
But what happens if rates change, and more importantly, change toward the lower end?
That guy will fire up his spreadsheet... and buy more stocks until he reaches the then current three year yield on risk free bonds.
This is where I part company with the mainstream, VAR guys, and the rest. Because in my small world, I want to separate the return stream which is due to interest rate changes over time and what I call the “real equity return” which is depurated from that part. But how?
Well, that's possible. As I said I used Bloomberg LP data, but most of those are publicly available as in here1:
This is the German ten year yield from the late 80ies to today. This is the slide in the kid park that helped both governments to spend more and more money, and equity managers to look good. In this case let's take the Dax index:
Now we have the two: how can we make a comparison? The easy and partly misleading way is to use a return comparison start to finish using a spreadsheet, and under the assumption that rates longer than ten years are “flat”, i.e. that 35 year bonds at the start would yield the same as a ten year bond: in that case , equities beat bonds, 7.2% vs. 6,7%, for a grand 0.5% per year. Rates at end of January 1989 were at 6.72%, the Dax on the same date was 1,312.73. On December 30th 2022 the Dax closed at 13,923.59, which puts the compounding annual rate at 7.2%.
Yet, how much of that winning bet depended on equities providing a return of their own and how much of that was due simply to lower rates making otherwise unattractive investments viable and inflating those which already were at the start?
For that, I used monthly gross yield data to calculate the price of a ten year zero coupon. Then for each month end I calculated the “deflator” as the current value of that fictional zero coupon bond divided by the initial value. Having done that, by dividing the current value of the DAX index by that deflator I have a kind of “Pure Equity” Dax index.
From that it's easy to ascertain this: how much the rising tide of bond prices, mostly but not entirely due to Central Bank policies, pushed the index beyond what would otherwise had been?
This is the price graph of the zero coupon bond. As you can see it went from prices in the low forties in the early 90ies to OVER 100 in the #NIRP (Negative Interest Rate Policy) period. To be more specific, think of that red line as a making tide in Saint Malo: yes, your boat sits higher and higher relative to the buildings along the shore. That doesn't make the skipper a new Orville Wright.
Also, like the tide, it's a trend that is not sustainable over time. The red line gained 50 points in 30 years. Postulating that this could continue means that 30 years from 2019, savers would be glad to invest 150 Euros in a government paper returning 100 EUR nominal in ten years instead of withdrawing cash at an ATM and putting it in a tin box buried in the garden. Let's just put that concept in the “unlikely” column.
In this Graph, the red line is the Dax index as publicly reported, while the blue line is the same Dax but with the bond kicker taken out, both rebased at 1.000 in January 1989. If we search for the highest and lowest differences, these data come out:
From September 1990 to August 2019, the German index (which includes dividends reinvested) had a performance near +800%. BUT, the same index depurated of the “tidal wave” of bond support, did about 250%, meaning that over two thirds of the increase could conceivably be ascribed to the fall in nominal bond rates. I honestly don't know how much that is understood by final investor, but I never saw it written anywhere, hence why I did.
So what are the conclusions? My first one is : beware of historical analysis of equity returns that pay no heed to this fact. As I said earlier, I find it quite unlikely that we will see the same scale of appreciation in bond prices as we've had for several decades now.
The second, and I beg pardon for beating my own drum, I am rather queasy about the dependability of the current generation of asset managers. Anyone younger than my sixty years of age has never seen a period of stable interest rates, let alone a steady rise, an outcome which is possible.
For those interested in the spreadsheets and the methodology, I can be contacted via Twitter through @Gbponz, or through Tokos .
Comments
Post a Comment