- The German bond’s 3% loss on a 12 basis point yield move shows how risky bonds are right now.
- The value of the S&P 500 should be around 1,600 but could go lower with bad economic news.
- Bonds and stocks seem very risky as they both have low yields and large downsides.
Last Friday was a pretty scary day in the financial markets. The S&P 500 lost 2.45% and bonds also lost ground due to higher yields.
Stocks and bonds are correlated and don’t provide quality diversification. We have been warning about the risks inherent to bond investing for a while with warnings that the low yields mean high risk and low returns.
The magnitude of what could be lost by investing in bonds can be better understood by taking a look at the German 10-year bund price which jumped from a negative -0.11% yield to a positive 0.01% yield which represents a change of 12 basis points.
Figure 1: German 10-year bund. Source: Investing.com.
The value of the German bund fell almost 3% in a matter of two days. A FED decision to increase interest rates, any sign of inflation, or the reach of global understanding that monetary easing does not work anymore after 7 years would have a severe and quick negative effect on bond values and stock yields.
The fact that there has been no inflation and interest rates have been kept low for a long period doesn’t mean that we can just exclude those factors from our risk assessment models. So, be aware of those that use models based on the 5-year data.
What’s Going On In The Markets?
We aren’t just going to list the latest news, but instead will try to differentiate between cause and motive. Cause is the fundamental factor behind market moves and the motive is what triggers it.
There have been plenty of motives behind last Friday’s move. At the beginning of last week, it seemed like markets didn’t want to see the reality and everyone was happy with low interest rates and slow economic growth. But then suddenly markets woke up as the European Central Bank (ECB) president, Mario Draghi, didn’t do anything.
Markets, like addicts, were expecting increased stimulus, which didn’t come. Draghi defended ECB policies and urged governments to spend more to spur growth and inflation, which is a sign that central banks may have reached their limits.
On top of the Europeans not pushing for more easing, the rumor is that the FED will soon increase rates as the economy, and especially the markets, are heating up. A 76% probability that the FED will raise interest rates in the upcoming meeting is concerning considering what happened to German bunds when yields increased by just 12 basis points.
Figure 2: Probability of FED rate increases in next meeting. Source: CME Group.
Also on Friday, the news broke out that the Bank of Japan (BOJ) might be running out of government bonds to buy. Without bonds to buy, the current purchases just create an asset bubble and have no direct impact on the economy. The increase in BOJ’s ownership share of government bonds without positive economic effects creates lots of questions.
Figure 3: BOJ’s share of Japanese government bonds. Source: Wall Street Journal.
This might all be good news for the long term as central bankers are beginning to understand that their monetary policy magic works only up to a point, after which structural reforms and increases in productivity are the only options left. If this process has started, there will be severe market implications as markets will be left to themselves. As we know that the current bull market is mostly fueled by the FED, we can expect rough times ahead.
Figure 4: The FED’s balance sheet and the S&P 500. Source: FRED.
The question now is “how bad can it get?”
We saw pretty sharp declines of slightly above 10% in August 2015 and January 2016, but a real bear market should be worse. By plotting a straight line through the middle of the last three bull markets, we can see an indication of where the S&P 500 could end up based on the last two bear markets.
Figure 5: S&P 500 potential in a bear market. Source: Yahoo Finance.
We shouldn’t be surprised to see the S&P 500 fall to a value of 1,600 which would give it a more realistic PE ratio of 18. If panic kicks in accompanied by a recession, we could easily see the S&P 500 dive below the 1,600 mark, but such a situation would probably be very short term as it was in 2002 and 2009. If this projection comes to fruition, it will present a great buying opportunity.
If central bankers decide it’s time to remove the foot from the gas pedal and put more pressure on governments that have been enjoying low interest rates without implementing much structural reforms in order to increase the potential of an economy, we could see sharp declines in asset values like the ones seen last Friday.
If central bankers decide to protect the markets by increasing stimulus, the cycle will just be postponed as the real issue lies in productivity.
There is no easy answer to the question of what to do now as a lot of things could happen. Owning assets seems like a high risk, low yield situation, therefore investors should create a portfolio that will protect themselves no matter what happens, which right now doesn’t mean to diversify with bonds and stocks as those assets are correlated.
An insight into a higher level of diversification can be reached by reading our article here.