Nothing “Perverse” about the Flight to Bonds
The renowned CIO of Legg Mason, Bill Miller, has written an opinion piece in the FT today, criticizing investor preferences for bonds over equities, as demonstrated by the re-direction of equity fund flows toward bond funds. He believes that things are getting better, based on GDP numbers, credit spreads, and the level of bond re-financing. These are not, in our view, good indicators. GDP figures are, at best, inconclusive; the inventory cycle contributed 3.4 pp of the 5.7% Q4 GDP number and the other 2.3 pp is likely substantially stimulus-related. Furthermore, we could expect support from net exports to decline thanks to the rally in the dollar and the underlying causes of the risk aversion that drove it, i.e. the need for demand hitting fiscal adjustment in the eurozone periphery. Credit spreads have been distorted by extraordinary liquidity measures and a lack of imposed losses on debtholders and the level of bond re-financing reflects manufactured and unsustainably low rates. A constructive view on equities, in our view, necessarily assumes above-average inflation and good growth and underestimates the risk of a double-dip. This assumption stands in stark contrast with RGE’s forecast for anemic growth in the developed economies and glosses over significant slack in labor markets and excess capacity across sectors and regions.
There is nothing perverse about the ongoing rotation toward bonds nor is there a disproportionate affinity to the asset class. U.S. investors have generally been advised to have a high equity allocation in their portfolios, which should attenuate as they approach retirement. Given that we have witnessed two significant collapses in equity prices within a decade, it should not at all be surprising that investors, particularly of the retail variety, have become sensitized to equity volatility and seek to re-balance portfolios. This is a phenomenon affecting primarily retiring baby-boomers, but if younger investors have become equally sensitized, this may signal a fundamental change in preferred/advised asset allocation for individuals.
Equity values were historically supported by debt in various ways. Western corporates had incentives to be more geared than otherwise because executive stock option compensation benefited from increasing debt with tax-deductible interest to boost equity returns. Though Corporate America has deleveraged, it might have gone further if these distortions were absent or repealed by legal or regulatory reform. Banks, with tax deductible hybrid capital, their own leverage, and the financial system as a whole contributed too, via leveraged agents like private equity and hedge funds. In the ongoing deleveraging this is likely to continue to constrain equity upside, especially relative to corporate bonds – especially high-grade, but also high yield in a yield-seeking zero-rate and falling default rate environment.
Granted, treasury yields are very low and credit spreads have made huge moves in 2009. To state that the potential for greater returns resides in equities at this point in time (or any point in time when yields and traditional equity valuation metrics are low) is a no-brainer. In our view, though, individuals are currently prioritizing principal retention over returns. And why shouldn’t they? 12-18 months ago the financial system was on the brink of collapse and asset prices fell off a cliff and yet in the aftermath, we’ve seen an aversion to imposing losses on debtholders. Equity markets rallied significantly since March 2009, but a further upward trajectory is not a given if some investors have run out of breath and perhaps now see a good time to rotate into what they perceive as a ‘safer’ asset class. Furthermore, if anemic growth is on the cards and credit contraction continues, forward earnings and cash-flow projections could be revised down, with negative effects on equity pricing; in a perverse twist, corporate dividends may remain solid, if only because companies find that there is no immediate or better way to invest the funds in a limping economy.
No Responses to “Nothing “Perverse” about the Flight to Bonds”
john • February 10th, 2010 at 8:55 pm
Its nice to see Bill Miller believs in Fairy Tales and the Published Numbers. No, MKTS, Economy and etc. are not getting better, the worse is yet to come. We are seeing the next chapter in this Financial Crisis – Soverign Debt – before it ends there will be a major systemic event to the Financial System. But, I am a Bear so my views are shaded.
