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Why 3.5 is the number all investors should be looking out for

3.5

The Financial Times’ Adventurous Investor, David Stevenson, writes for Glint on why the big decider for the global economy might be the number 3.5…

Over the last few months I’ve become something of a news cycle cynic. As a journalist this sounds an almost heretical statement – it’s like a Bishop denying the existence of god. For journalists, surely, our whole reason for being is to report on the news. But the important distinction is that I am a financial journalist and many years of bitter experience – and half arsed editorials – has taught me that financial markets and macro news is a match made in hell.

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On paper big picture political changes obviously drives markets. Candidate Trump hoves into view and wins the election – markets panic. Brexit trundles into view: Head for the exits. Yet short term reactions to these news developments rarely gives us a glimpse of the real long term drivers behind the pricing of assets such as equities, bonds or gold. I’d argue that news flow is 99% noise.

Trump press

99% of the news flow is noise

Trump threatens a trade war: Short term day traders react, everyone else mostly yawns. Which is not to deny that a full scale trade war wouldn’t be terrible for financial assets, it’s just that the news cycle itself tells you very little about what to worry about. As an aside, Trump is also a master of controlling the news cycle and so you should treat just about everything he says with a considerable amount of scepticism.

In fact, I’d go so far as to say that investors should probably completely ignore the news cycle unless we have a:

  1. Proper war involving thousands dead – which would be a true calamity
  2. The rise of outright hard Left or hard Right political regimes – think Corbyn with a 50 seat majority and the House of Commons jam packed full of Momentum supporters or
  3. Massive tax rises or currency controls (usually proceeded by factor number 2)

Stock and bond markets are largely powered by brutally simple to understand drivers such as the current level of interest rates and inflation rates, as well as the current state of the business cycle, which is in turn partly determined by those interest and inflation rates. So, its against this backdrop – and my general quest for news that really matters – that I suggest you visit a web page housed the main economics monitoring organisation in the US, the National Bureau of Economic Research or NBER, about cycles: http://www.nber.org/cycles.html.

Given how dismal most economists are at explaining why ‘stuff’ happens, this web page is a model of brevity and analysis. It discusses the various business cycles in the US since 1854 – 33 in total. It looks at the average length of the contraction phase – 17.5 months over that full time period – and the average duration of the expansion phase – 38.7 months. Crucially, it also tells us that the average peak to peak of a business cycle is 56.4 months. If we narrow the time period down and look at the period since the end of the Second World War, that peak to peak period increases to 68.5 months, while the average expansion period is of 58 months. For the record the last peak was in December 2007 and the current expansion phase started in June 2009. So, by whatever calculation or reference point you choose, we are well over 100 months into the expansion phase or after the last peak.

In simple to understand language, we are very late in the business cycle. There have only been three other business cycles that have lasted between 100 and 127 months. We are currently over 130 months from the last peak and 108 months from the last trough.

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So, when you hear investors worry about Trump/North Korea/China/Eurozone travails/bird flu, rest assured that there’s a good chance that none of that matters in the slightest. What really matters is that we are due a recession in the US in the next 24 months.

That is just a plain, hard, statistical probability.

Maybe we’ll defy the rules and somehow avoid the slowdown….but the odds are that we won’t.

Which means that we need to keep a very watchful eye on indicators that suggest we are top of the cycle (inflation) and at peak excess optimism (indicators of leverage). The good news here is that all sorts of people with the words macro and analyst in their job title watch this stuff relentlessly. The current consensus is that the US yield curve, profit margins (before tax) and employee compensation are now sending a clear message that the current cycle is ending. Analysts at French investment bank SocGen have also observed that the rotation from accommodative monetary policy to tightening should put some upward pressure on funding costs which is also pretty bad news for corporates.

As a result they now highlight two – yes just two – areas of concern.

  1. US small caps appear at risk on several metrics, including record-high Net Debt to earnings before interest, taxes, depreciation and amortisation or ‘EBITA’.
  2. Eurozone peripheral countries (Spain and especially Italy) could be under pressure from rising interest rates as both countries have currently low interest coverage ratios (earnings before interest and taxes – ‘EBIT’ / Interest Expenses) amid historically low yields and spreads.

But, for me, the really concerning charts are below. They look at flows of money into and out of bond funds in Europe. Investors are pulling money out of bond funds at an alarming clip. What do these institutional investors know that the rest of us don’t?

The exodus of money from bonds

The exodus of money from bonds

The simple answer is that to a man and woman, they are obsessed by one key number – the yield on 10 year US Treasury bonds.

The next chart below shows this yield as a percentage over the last ten years. Notice how it’s heading towards 3%. By the time you read this, it’ll probably have breached that barrier. And for most bond investors, that is very BAD news. Traditionally rising yields – powered by expectations of increased interest rates – are an indicator of an imminent slow down. Crucially as bond yields rise, the price of bonds fall. This means that bond holders, even though they are getting a higher yield, or dividend payment annually, panic because the overall value of the bond is less if they want to sell it. It is similar to a share hemorrhaging value. Thus, right now investors seem to be getting out of bonds anticipating even bigger losses.

The rising of bond yields to that magic number

The rising of bond yields to that magic number…

As these bond yields grind higher, all things being equal, we might expect more uncertainty in stock markets – higher yields imply that the risk-free rate from cash is becoming more attractive.

So, in very simple terms, for most of the history of Western Capitalism, a push above 3% is usually bad news for investors in bonds because:

  1. They are losing the value of the bond
  2. It is an indicator that investors expect inflation to rise
  3. It is a signal that investors are worrying about an imminent top of the cycle and subsequent slowdown
  4. and, ultimately bad news for equity investors as that slowdown gets baked into estimates for profits growth.

So, if you have to watch anything in the news, watch the 10 year bond yield rate. But, as with all things financial, this 3% barrier is ‘complicated’. US bond yields hitting 3% might not actually be the signal for doom and despair I have conjured above – or at least not according to Jonathan Golub, chief US equity strategist at Credit Suisse. He thinks that the yield level to watch out for is actually 3.5% – or at least that’s what he told investors in a recent note to clients. “Everybody says that rising yields are bad, but if you put aside that preconception and look at the data, you see that it’s not the case…If rates rise from 3%, that’s a good thing.”

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Golub has analysed returns from the S&P 500 for a period starting in 2014 to the present and estimates projected US equity returns after focusing on rising bond yields. At bond yields of below 2% the equity markets return 62%, at between 2% and 3% they return 36%, while between 3% and 4% there’s a small decline of just 3.6%.

The bad news though is that once we get to 4-5% bond yields, the S&P 500 could drop by as much as 40%. According to Golub what really matters is the trajectory of the yields after 3.5%. If rates stay unchanged at this level, the S&P 500 probably won’t react. The further away yields rise from the 3.5% threshold, the bigger problem it becomes. “If yields rise from 4%, that’s a problem,” he said. “If rates rise from 5 percent, that’s a bigger problem.”

So, the bottom line is terribly simple. Watch the 10 year US bond yield. Wince at 3%. Get concerned at 3.5%. Start to worry at 4%. And sell all your equities and risk assets once it hits 4.5% or 5%.

David Stevenson writes the Adventurous Investor column for the Financial Times, for whom he has also written several books. He has previously worked for the BBC, ITV and Channel 4 and has advised a number of firms on investment and communications, including HSBC and EY.

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