Tuesday, 25 June 2013

Well what a torrid week! Has the bond market definitively cracked? What next...

25/06/2013  A Tough Week for Investors

After a torrid week for pretty much all financial assets (stocks & shares, bonds, precious metals...), we can perhaps let the dust settle to see where we really are. 

Central banks have clearly dominated the investment landscape, with mounting fears over the US Federal Reserve starting to "taper" their reinvestment of cash in US government Treasury bonds some time from September this year, and also the People's Bank of China tightening up on credit standards in order to cool the growth in credit there. 

Volatility has awakened, but not yet near 2012 highs

The volatility in equity markets has evidently spiked as a result of the drop in stock and bond prices over the week, with the 3-month implied volatility level on the US S&P 500 index back up above 20 as of yesterday. 

S&P 500 3-month implied volatility back above 20, 
but still a long way from 2012's highs
Source: St. Louis Fed

Bond markets have been hit by the central bank fallout

Bond markets have clearly suffered too, with bond yields rising (and thus bond prices falling) to their highest levels this year. This fact has prompted many calls for the end of the 30-year bond bull market, with some even declaring the arrival of "a lost decade" for bond investors, i.e. a decade where bonds will make no money at all for investors. 

Yes European bond yields have risen, but are still very low by historical standards
Source: iShares/Blackrock

That said, let's not lose sight of the fact that the interest rate effectively paid by large European companies to borrow money over a number of years in the bond markets remains, at an average of only 2.3% for investment-grade companies and 4.2% for high-yield rated companies, still close to record lows. Thus while I DO believe that the majority of government and corporate bonds represent fairly poor value right now, I would not think that the rise in yields that we have witnessed recently is in any way catastrophic for investors or indeed, for the wider economy. 

Some sectors look ugly...

Within the European stock market, there are a few industries/sectors that are in a clear down trend, most notably those sectors linked to commodities, like the Oil & Gas sector and Mining:

Oil & Gas (SXEP) has been trending down for the past year...

 As has the Mining sector (SXPP)
Source: bigcharts.com

But at the same time, not all is lost for the stock market investor! There aare still quite a number of industries that look promising to those looking to invest on this market correction, including various areas of technology such as Semis and Nokia:

Semiconductors are just pulling back to a clear support level...

 Nokia is slowly recovering too
Source: bigcharts.com

And don't give up on Japanese equities either just yet...

The Japanese Nikkei index is starting to recover after a sharp sell-off
Source: bigcharts.com

All in all, the so-called carry trade (explanation here: WSJ: The carry trade ripping across Wall Street) has been unwinding at a rate of knots as worried investors retreat from equity, bond and precious metal investments in the wake of Fed President Bernanke's recent pronouncements. 

However, think of this: the higher that US government bond yields go, the higher that long-term fixed mortgage rates also go, potentially stalling both the US housing market recovery and US consumer confidence, in the process hurting US economic growth at a time when it is still relatively fragile. 

So, the higher that bond yields rise off the back of the fear of the Fed withdrawing monetary stimulus support for the US economy, the more likely it becomes that the Fed has to keep all of the monetary stimulus in place to prop up faltering economic growth as US housing weakens. All in all, judging by economic indicators such as the rate of employment growth, the ISM manufacturing survey and capital spending growth, the US economy is not at all in a robust growth mode right now (see for instance, What's Capping Capital Spending?). 


Stock markets in Europe have pretty much now given back all of their gains for this year to date (although not so bad for mid-caps), offer good value in terms of P/Es and dividend yields, and may now be stabilising. Investors need to be selective about which sectors to put their money into from here, particularly given that May has passed and we are now in what is traditionally the poorer 6-month period (June-October) from the point of view of stock market returns. 

I would personally stick with Technology, Healthcare, Luxury Goods and Insurance, but would avoid the likes of Oil & Gas, Mining, Utilities and Food & Beverages (all of which have ugly-looking 1-year charts). 


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