Bond market – apocalypse now?
Tim Price Jun 13, 2007
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Recent headlines have made much of panicky developments in the equity markets, but it is arguably not there but in the bond market where the real action has been occurring. This isn’t a good thing.
Writing in the Financial Times (“Could the party be drawing to an end for bond investors ?”) the appositely named Tim Bond of Barclays Capital suggests that a colossal bubble in global credit markets is now in the process of deflating. His argument is that demand for bonds surged in 2003 and in subsequent years on the back of significant growth in global foreign exchange reserves (step forward China and India).
But it wasn’t just foreign central banks that were sizeable investors into the world’s bond markets.
They were joined by pension and insurance funds, driven by regulators insistent on tightening institutional solvency requirements. Horribly but inevitably, these institutions sold out of stocks – at the low – to buy bonds – at the high.
Bond concludes that those inflows into government debt markets drove long term interest rates down to abnormal and unsustainable levels. The then Federal Reserve chairman Alan Greenspan even alluded publicly to the “conundrum” of such low long term rates at a time of otherwise impressive global economic growth. Those rates in turn fuelled a surge in the world economy, commodities prices, property prices, and frenzied conditions in mergers and acquisitions and leveraged buyouts. But the party may now be coming to an end.
As companies look to releverage their balance sheets (in part to escape the clutches of avaricious private equity firms) by issuing debt, the overall supply of corporate debt is surging. But the number of buyers for this debt may be shrinking. And the key development here is China’s recent decision to invest $3 billion not, as it has historically, into US Treasury bonds, but into private equity group Blackstone. Steve Schwarzman, co-founder of Blackstone, described the purchase as “an exceptionally important paradigm shift”.
China’s State Investment Company has committed to holding the Blackstone stake for at least four years. And this may just be the start.
As Bond suggests, “China alone may be responsible for a redirection of capital away from bonds and into equities worth some $300 – 400 billion over the next 12 months or so.”
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So last week’s dramatic sell-offs in stock markets look like being largely technical in nature – the fundamentals for equity investments would seem to remain sound, as huge sovereign funds reallocate assets away from conventional, relatively low risk fixed income assets and into higher risk assets such as listed stocks and private equity.
But the flip side of this development is that government and particularly corporate bond yields could conceivably drift much higher, making the prices of those bonds drop through the floor. And if bond prices do collapse, equity markets may not be able to shrug off the deteriorating price trends of their traditional asset class rival. In which case, there is no ‘safe haven’ of any significance, except cash.
Bond concludes his argument with words of extreme caution: “Like all markets, both bonds and equities are subject to the inexorable law of supply and demand. While this redirection of capital flows will initially benefit equities, we can be sure that the impending increase in bond supply and decrease in bond demand will lead to a gradual deflation of the great bond bubble.
As this process unrolls, we can be equally sure that the expected returns underpinning many recent investment decisions will be subject to a similar deflation of prospects.” A more abridged version of Bond’s article might read: invest in haste; repent at leisure.
Turning to the wider markets...
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In London yesterday, M&A news saw the FTSE 100 gain 62 points to close at 6,567, its highest level of the day. Cadbury Schweppes was the day's second-highest riser after the confectionary and beverage group announced that it is to sell its Butterkist popcorn brand. Miners including BHP Billiton and Rio Tinto were also higher on rising metals prices. For a full market report, see: London market close
On the Continent, the Paris CAC-40 was 56 points higher - at 5,940 - and the Frankfurt DAX-30 was 115 points higher, at 7,706.
Across the Atlantic, stocks closed mixed after a volatile session. The Dow Jones closed a fraction of a point higher, at 13,424. The S&P 500 gained one point. And the tech-heavy Nasdaq fell one point, with Apple sliding 3% as the first day of its conference passed with little mention of the much-anticipated iPhone.
In Asia, the Nikkei fell 73 points to end the day at 17,760.
Crude oil gained over a dollar to reach $65.97 in New York yesterday, but had fallen back to $65.75 this morning. In London, Brent spot was slightly lower, at $70.51 a barrel.
Spot gold was holding on to yesterday's gains this morning, last trading at $653.00 compared to $653.40 in New York late last night. Silver, meanwhile, was steady at $13.20.
Turning to the foreign exchange market, the pound had strengthened against both the euro and the dollar this morning - trading at 1.9728 and 1.4779 respectively - as comments by Bank of England Governor Mervyn King added to expectations of interest rate hikes. And the dollar was trading at 0.7490 against the euro and 121.74 against the Japanese yen.
And in London this morning, shares in HBOS slumped by as much as 4% as the mortgage lender warned that its share of the UK market is set to fall by one-half in the first six months of the year. The company is struggling to maintain profit margins as lending margins decline.
And our two recommended articles for today...
Metals shortages have a silver lining for investors
- A recent report in the New Scientist has revealed that many metals - most notably, silver - look set to run out in the next few decades. It's going to be a serious problem - and a huge investment opportunity. For Merryn Somerset Webb's favourite plays on metals shortages, read: Metals shortages have a silver lining for investors
Why buy-to-let sales are bad news for the property market
- Sales of buy-to-let properties jumped in the first quarter and rents are beginning to rise as well, just as they did in the months before the last property collapse. For more on the outlook for renters and buyers - plus updates on other key markets from the Onassis team - click here: Why buy-to-let sales are bad news for the property market
Like to hear more from Tim Price? Get privileged access to what the top City names are really thinking, doing and tipping with his fortnightly email investment service. Click here to find out more: The Price Report
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