The great gilt debate
Tim Price Aug 30, 2012
In 2010, Bill Gross, head of one of the world’s top bond funds, warned investors to get out of UK gilts. Yet since then they’ve soared in value. Can the rise go on? No, says Tim Price, but James Ferguson (below), a long-term gilts bull, thinks it can.
Should you buy UK government bonds, also known as gilts? The answer has to be a resounding ‘no’. If there is one lesson we can take from Carmen Reinhart and Kenneth Rogoff’s magisterial study of financial crises (This Time is Different), it’s that episodes of debt default – and associated economic trauma – occur much more frequently than we might believe.
Reinhart’s and Rogoff’s chart of sovereign debt crises, stretching back over two centuries, shows quite clearly that the world has seen at least five major cycles, within which a significant number of countries have been either in a state of default or debt restructuring. Notably, each apparent lull has been followed by a dramatically higher spike, and a wave of new debt crises.
Take the 1950s, for example, when almost half of the countries in the world were caught within the grip of either default or restructuring, after the colossal public expenditures of World War II. Since it is now widely accepted that we have just lived through one of the largest credit bubbles in history, a credit bubble that was global in scale, it would be foolish not to expect the aftermath to be comparably dramatic.
My next piece of evidence for the prosecution (the chart below, which shows debt carried by the G10 nations) comes via Morgan Stanley. We know that many developed economies are labouring under historically high debt-to-GDP ratios, Britain included. (Virtually no sovereign state in Europe would now qualify for eurozone membership under the 1992 Maastricht criteria, which stipulated a maximum debt-to-GDP ratio of 60% for countries adopting the euro.)
But factor in financial sector debt, and Britain’s debt profile knocks even Japan’s into second place. Very ugly. Having bailed out the banks and assumed many of their liabilities with taxpayers’ money, the British government has effectively bankrupted itself.
So how is it that gilts have managed to avoid the same fate as government debt issued by troubled nations such as Greece, Portugal and, more recently, Spain? The factor most often cited is that, thanks to being outside the euro, the Bank of England is free to print money to its heart’s content. This has prevented yields from soaring and prices from tanking, as has happened to the debt of ‘peripheral’ eurozone states.
But be careful what you wish for. Responding to credit ratings agency Standard & Poor’s downgrade of the US last year, former Federal Reserve chairman Alan Greenspan crowed: “The United States can pay any debt it has because we can always print money to do that. So there is zero probability of default.”
Greenspan’s argument, as befits one of the prime villains of the piece, is almost entirely specious. He was just a little more candid before a Senate banking committee in 2005 when he commented, in relation to social security benefits, that “we can guarantee cash benefits as far out and at whatever size you like, but we cannot guarantee their purchasing power” [emphasis mine]. This is the problem, overlooked or ignored by those investors currently buying fixed-coupon gilts at eye-watering yields, which all happen to be negative in real terms (ie, after adjusting for inflation, no gilts pay enough to compensate for inflation).
How has Britain and its gilt market got away with it so far? In short, by rigging the market. A little local difficulty in the eurozone may account for a small part of current gilt-price insanity, as investors flee towards anything that seems to be a safe haven. But the main reason for the artificially high price and low yield on gilts is that the biggest buyer is the state itself, in the form of the Bank of England. The Bank’s great quantitative easing (QE) experiment, plus hefty dollops of regulation, effectively force (largely state-owned) banks to own gilts too. The same goes for pension schemes, for whom gilts have always been the preferred vehicle for matching current and future liabilities.
So the ‘why?’ is quite straightforward: the government and its central banking agents have manipulated the market in favour of a horribly indebted government that badly needs to issue more and more gilts into what would otherwise be a terribly sceptical market.
So when Pimco’s Bill Gross warned that gilts were a dangerous investment to hold on to, he may have been a little premature, but he wasn’t necessarily wrong in terms of the ultimate outcome. Because, as Margaret Thatcher also warned, you cannot buck the market trend forever. The breaking point may well come when the next stage in the eurozone endgame destabilises the banking system (again) – and panic across debt markets finally washes up on our own shores. Since our banking sector and government finances are explicitly joined at the hip, one cannot survive without the rude health of the other.
As Reinhart and Rogoff warn, debt default crises are often accompanied by inflation, banking crises and currency debasements. Our future promises to be unusually lively – especially for investors who hang on to gilts.
• Tim Price is director of investment at PFP Wealth Management. He also writes The Price Report newsletter. Visit www.moneyweek.com/TPR for more.
Little has changed about the ‘buy’ story
James Ferguson, chief strategist at Westhouse Securities
When Pimco’s Bill Gross warned investors to get out of gilts in early 2010, he didn’t pull his punches. Using his characteristically evocative language, he referred to gilts as “sitting on a bed of nitroglycerine”. His own fund had also sold out of US government debt (treasuries), which he viewed with almost equal disdain.
Yet since then, the major developed world government bonds (gilts, treasuries, German bunds, Swiss bonds and Japanese government bonds (JGBs)) have enjoyed an unprecedented bull market. During 2011, government bonds were the world’s number-one asset class, even outperforming gold. So far this year, bonds have again left the now-lacklustre yellow metal in their dust. Gross has subsequently, and painfully, reversed his stance, taking Pimco back into an overweight position in treasuries. Isn’t it ironic that Gross, who coined the term “new normal” to describe the uniquely challenging environment the western world now faces, was himself unable to see just how radically the rules had changed?
At the time of Gross’s “nitroglycerine” warning, Tim Price and I debated in MoneyWeek’s pages whether readers should have heeded his advice to flee gilts or not. I gave the reasons why I thought Gross was wrong, and why gilts were in fact a buy.
Today, despite the huge rise in gilts (and the commensurate collapse in yield) little else about the ‘buy’ story has changed. Naturally, the higher the price of any asset goes, the less its fundamental appeal (although it’s a wonder how many investors seem to forget this). There is far less upside in gilts today than there was in early 2010: the yield on the ten-year gilt has fallen to around 1.5%, from more than 4% back then (yields fall as bond prices rise). But that doesn’t necessarily mean that gilts are going to enter a bear market, with yields shooting back up. Yields on JGBs, for example, have remained below 2% since early 1999. They have also enjoyed a new bull market over the last four years (ten-year JGB yields are now 0.8%).
What is clear, however, is that once government bond yields get below 2%, they become increasingly volatile and vulnerable to sharp upward corrections (in other words, bond prices can fall sharply). JGB yields trebled (from 0.7% to 2.2%) in the fourth quarter of 1998, and again in the third quarter of 2003 (from 0.43% to 1.56%). US treasury yields similarly doubled in the first half of 2009, jumped by two-thirds in the last quarter of 2010, and even increased by as much as a third over the last month. All of this means that would-be investors in such government debt now have to be wary and only buy on weakness.
In any case, US treasuries are no longer a fundamental buy. That’s because, in America, banks are finally lending again, and so broad money supply is growing, without the artificial help of quantitative easing (QE). I’m sure Federal Reserve chief Ben Bernanke won’t be able to resist the temptation of deploying QE for the third time, but according to the central bankers’ textbook, he technically no longer needs to in order to prevent deflation. So while the American economy may still be sickly, at least the monetary policy transmission mechanism is functioning normally again.
However, we can’t say the same for Britain, and therefore, for gilts. The monetary policy transmission in Britain remains broken. The British economy shrank by 0.5% in the second quarter, having also shrunk in the first quarter – so technically speaking, we’re in a new recession. That looks set to continue in the current quarter, not least because the country took three weeks off to watch the Olympics, which is hardly likely to have boosted economic output.
Meanwhile, bank lending not only continues to slide, but three of our big four high-street banks have a combined £250bn of loans to customers in excess of their retail deposits. In other words, they are lending significantly more than they hold in deposits. You can use this “wholesale funding gap” as a decent approximate measure of just how much bank lending still needs to shrink by (so that banks loans are matched by their deposits once again).
When banks shrink lending, it’s extremely deflationary, which explains why the Bank of England has spent an extra $175bn in QE asset purchases since December – it has been forced to, in order to prevent the broad money supply from collapsing. And with consumer price index (CPI) inflation at a three-year low, there’s nothing to suggest that gilt prices are going anywhere but up (and yields down, therefore) for the foreseeable future.
The important thing to realise about the current environment is that many of the normal rules don’t apply. Europe’s banks are only just starting to contract their lending too. Over on the Continent, the excess of loans over deposits could be more than €3trn. Everything we’ve experienced so far in America and Britain is a template for what is about to be visited on Europe.
The European Central Bank (ECB) will lose what little control it retains over the monetary policy levers, forcing it to adopt QE or face a deflationary contraction in the broad money supply – also known as a full-on depression. But the size of the bond purchases required in Europe will drive yields over there down to super-low levels too, just as has happened in Japan, Britain and America.
Hence the most likely scenario is that gilt yields remain around these low levels. And the risks are yields will go even lower, rather than materially higher, for quite some time. The likely disruption in markets from Europe as the German Constitutional Court rules on the ECB’s ability to perform QE (in September) and as the US hits the post-election ‘Fiscal Cliff’ (when many fear that scheduled spending cuts and tax hikes will hammer US economic growth if politicians can’t agree on a deal to avoid the tightening), will only exacerbate these bond market trends.
As for the endgame, that won’t come about until the banks stop shrinking their loan books. That’s likely to take at least another two to three years, and possibly longer. Until then, it’s going to be more disappointing GDP ‘growth,’ consistently low core CPI inflation, super-low rates and gilt yields, and more QE. As a result, the ongoing outperformance of defensive, high-yield stocks with strong balance sheets over their more growth-orientated peers also looks set to continue.
So what should you do now?
When it comes to the gilts debate, the MoneyWeek team’s sympathies have long leaned towards Tim Price’s view that they should be avoided at all costs. But the evidence of the past few years – plummeting government bond yields and soaring bond prices – shows that James Ferguson has been absolutely correct to hang on to UK government debt. It’s a valuable lesson in why it’s usually a good idea to take a contrarian stance even when every fibre of your being is screaming at you not to. However, are gilts still a ‘buy’ today?
We’re going to have to side with Tim again, and say ‘no’. James’s view – that ‘financial repression’ will win out, and that gilt yields will stay low – may well be correct. But at current levels, as he points out, there’s not much upside left. So rather than attempt to trade in and out of gilts, we’d agree that it’s a good idea to hang on to defensive, high-dividend paying shares, which have also done very well since the rebound from the financial crisis started in March 2009.
On the downside, should inflation take off or investors start to pay attention to Britain’s huge debts, then buyers of gilts at these levels could lose a great deal. That’s why we’d also hold gold as portfolio insurance against the danger of inflation and a sterling collapse.
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