According to Deutsche Bank (DB, Financial) analysts Jim Reid, Nick Burns and Sukanto Chanda, the global economy is at an “inflection point”, possibly spelling the end to a multi-decade run for nearly every bond class.
“We argue that we’re about to see a reshaping of the world order that has dictated economics, politics, policy and asset prices from around 1980 to the present day,” their report said. They believe that the trends which have helped fuel world growth since the 1980s—namely globalization and demographics—are starting to deteriorate, or even reverse.
To believe that these mega-trends will continue indefinitley would be a big mistake. “Extrapolation of the last 35 years will be one of the most dangerous things that policy makers and investors can do going forward,” their report continues. “This will likely make the next 35 years very different from the last 35 years.”
One of the asset classes to suffer most will be fixed income. For dozens of countries, government bond yields across are already near record lows, with many in negative territory.
Long-Term Is Not Necessarily Long-Term
When investors think about the term "long-term", they typically think in periods of many years, a few decades perhaps. Considering the last 30 years to be "long-term" however robs investors of an important historical insight: temporary trends often have the momentum to last for decades.
Included in Deutsche Bank's report is an important reminder of this insight, a table outlining just how odd the previous four decades plus have been. Since 1980, every single global bond market has seen positive annualized returns. The four preceding decades, however, were rife with measly or even negative returns.
This long-term bond party may finally be coming to an end.
Two Futures Await
“A challenging few decades likely awaits us,” they wrote, neither of which look positive for fixed income securities.
Here’s their “bull” scenario:
"Put bluntly the best realistic scenario for financial stability in the new era is that bond holders around the world see a slow real adjusted haircut over several years, probably over at least a couple of decades. The best example of this through history was the post WWII period where government debt was at similar levels to that currently seen. Over the next 35 years this debt was successfully eroded by a long period where nominal GDP was notably above bond yields. So bond holders took a large real haircut...
The four decades leading up to 1980 saw very bad overall real returns in fixed income. ... These hugely negative returns occurred largely without defaults and were terrible for investors but they obviously helped reset the financial system which was very over-levered. For such an outcome to have been achieved we needed financial repression and perhaps a reversal of the globalisation trends that had built up before WWI. There were substantial restrictions on the global flow of capital that allowed money to be trapped within countries thus allowing them to direct investments towards domestic policy issues such as financing the huge debt burden.
Such a scenario might seem alien to us in 2016 but it seems invariable that capital restrictions in some form or another will be a feature under this scenario. In many ways this has already happened as financial regulation has encouraged banks, insurance companies and pension funds to buy domestic bonds for non-relative value reasons. This will surely have to continue. Maybe it will be more difficult in today’s integrated world to limit international capital flows in the same ways as after WWII, so perhaps the cushion will come from a long period ahead of money printing and bond purchasing to ensure that there is no run on debt markets given the likely negative real returns."
Here's their "bear" scenario:
Rather than an artificial reflation and slow successful non-systemic deleveraging, there is a genuine risk of a more binary outcome where a major country (countries) see(s) a hard default on its debt taking a lot of other debt with it domestically and possibly internationally. This is probably most likely to happen via politics – especially in Europe if a country decides to leave the single currency.
Under this scenario, non-core government bond markets could see huge losses as the central bank backstop bid is removed. Government bonds lose under both scenarios but clearly scenario 2 would be very negative for economies that went through it.
Disclosure: I have no positions in any of the stocks mentioned above and no intention to initiate a position in the next 72 hours.
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