Kevin Cousins, Head of Research at PSG Asset Management
The US long bond has long been regarded as the ‘safe haven’ asset for global portfolios. This reputation was earned from nearly 40 years of strongly positive returns when risk assets sold off.
We believe that under most scenarios the US long bond will no longer perform its traditional safe haven role in the current macro environment, and that the majority of global portfolios are poorly positioned for what lies ahead.
“Insurance that pays you to take it”
US bond yields trended down from 1981 to 2021 and the annualised total return over this period was some 9%, compared to a CPI averaging 2.8% per annum. Long bond real returns were strong. Since the equity market crash in 1987, bonds have also displayed uncorrelated performance when risk assets sold off. This is driven by the so-called ‘Greenspan Put’, as investors anticipate monetary policy easing by the US Federal Reserve in response to economic or market stress.
This combination of positive long-term returns and non-correlation with risk assets has made long bonds an essential part of a portfolio for nearly four decades.
Consensus positioning is once again very long bonds
Investors have been concerned about a looming recession for some time, and since the US bond yield curve inverted in April 2022, and again since July 2022, portfolios have been loading up on ‘insurance’ by purchasing vast amounts of bonds.
However, the tried and tested ‘Greenspan Put’ has not worked this time around. In the first nine months of 2022, the S&P 500 Index delivered a total return of -16%. Instead of protecting portfolios as a safe haven, by the time the equity market bottomed in September 2022, the US long bond’s year-to-date return was a devastating -36%. Its worst return on record.
South Africans are often pessimistic about our country, so it may come as a shock to know that over the past three years, SA bonds have delivered a positive USD total return (+10%) while the US long bond has had a total return of -42% (both to end of September). SA bonds, in US dollars, outperformed by over 50 percentage points!
Pro-cyclical fiscal policy means trouble ahead
The essence of the ‘Greenspan Put’ is that monetary policy dominates the bond price formation process. A key assumption to this continuing is that the US maintains prudent fiscal policy. This has been sorely tested, firstly with the Trump tax cuts in 2017, which resulted in a budget deficit of some 5% at the peak of the economic cycle in 2019. This contrasts with a 2.5% budget surplus the last time unemployment was below 4% (under Clinton). Secondly, stimulus programmes under President Biden have pushed the current deficit to over 8%, despite the unemployment rate being at 50-year lows.
When the next recession finally arrives, there is little doubt that US policymakers (of either party) will opt for fiscal stimulus spending, which proved so effective in the aftermath of the Covid-19 pandemic.
In our view, this combined with the normal recessionary decline in tax revenues, will widen the US deficit between 5 and 10 percentage points from the current level, deep into the teens.
The US currently has the highest debt-to-GDP burden since the Second World War, and given these deficit constrains, debt is forecast to further rapidly rise to unprecedented levels.
Are US rates now pricing in the macro fundamentals?
The current significant positioning in bonds indicates that the consensus view is that bond yields are back at attractive levels. However, our research shows that over our investment horizon, current US bond yields do not compensate investors for what we believe are significant risks. While yields have risen, they are not high relative to history, on either a nominal or a real basis.
To add further complications, our research shows that of the current Federal debt burden of US$26 trillion, nearly 50% needs to be rolled before the end of 2025. If we add to this the expected budget deficits, we get a funding requirement of some US$17 trillion. This is 63% of current US GDP. By comparison, South Africa’s funding requirement is estimated at 15% of GDP over the same time period.
Who will buy US$17 trillion of US debt over two years, and at what rate?
The three largest holders of US debt are the Fed (after the long period of quantitative easing) and trade surplus countries Japan and China. Both of these countries have been reducing their positions, and the Fed is currently letting its debt holdings roll off as they mature in terms of their Quantitative Tightening programme.
The question is at what yield will the US find buyers for this vast issuance of debt? A market clearing yield is likely to be considerably higher than the current yield curve, which in turn will further increase the debt service burden at a time when the US government already spends more on servicing their debt than on defence.
The new safe havens in a volatile world
A consequence of the Fed ‘hanging tough’ and letting the market determine bond yields, could be a deep global recession. This is a very unlikely scenario, however. The probability that the Fed will step in on a yield spike and monetise US debt is very high. Policymakers have acted to alleviate any signs of economic and market stresses for many years now, and while the Fed initially may hold out, they are likely to pivot as those stresses become visible.
The implications of debt monetisation for the safe haven asset are significant. The Fed intervening to restrain bond yields is likely to result in a weak USD environment, and strong performance can be expected from commodities, emerging markets (EMs) generally and the bonds of commodity-rich EMs in particular. Gold will also play a key role as a portfolio diversifier in our view.
Investor portfolios will be well served by including these safe haven assets. They should also avoid long duration assets such as US long bonds and ‘high growth’ stocks with very high ratings. Global diversification, equity index hedges and cash holdings are further sensible additions to portfolios in this volatile environment.
ENDS
