Q1 2015 Review

Negative Yields

Why on earth would someone invest in something when they know, at the outset, that once they have received all their interest and their capital back, they will, without doubt, receive less than they had to start with? It is completely irrational, but it’s real! At the time of writing, the bond yields on German 2yr and 5yr bonds and the Swiss 10-year bond were negative. This means that you would be paying these governments for the privilege of holding your money. Even Nestle corporate 10yr bonds traded briefly in the negative territory. Why?

There are several possible reasons for this: Firstly, if you expect prices to decrease (i.e. deflation) then it can make sense to buy anything that gives returns greater than the level of deflation. So even if returns are negative on bonds, as long as the rate of deflation is even more negative, then the real return of the bond investments are positive. Secondly, and a little more sensibly, if Central Banks, like the ECB, come out and say they will be buying all bonds no matter what the price is, then you may profit by expecting the yields to drop further. Remember, bonds have an inverse relationship between yield and price, so if the yield goes even further down then the price will go up and the potential for capital profit exists. Since the ECB have said that they will be buying bonds for the next 18 months, then buying bonds at a negative yield is a reasonable trade if you have the stomach for the risk. The third reason for buying into a guaranteed loss is that you simply have to, because of the rules you fall under. E.g., a pension fund that is required to hold a certain percent in government bonds has to buy them no matter what the price is – no discussion required. The fourth reason, which is an extension of the third reason above, is that due to the limited supply of low risk bonds, if you want low risk, you have to buy negative yielding European government bonds at any price.

What does this mean for my portfolio?

We have been writing about low yields on bonds in this communique for the last three years. Each year we ask ourselves, “How low can yields go?” and each year we have seen our expectations exceeded. The message then is the same now, however it is more acute: each investor needs to ask himself, "How much risk can I tolerate and take in order to achieve my desired rate of return?"

• If the honest assessment is that no more risk can be taken, then the expectations of earning returns should be adjusted more towards preservation and avoiding mistakes.
• If the risk tolerance exists, which means that if plans do not work out there may be losses and that is something that can be lived with, than there are opportunities to exploit.

This is the essential issue. Taking risk means “I am prepared to lose money”; not taking risk means “My focus is on preserving my money”.

Many investors around the world are continuing to increase their allocation to equity. Global portfolios for balanced clients are seeing as much as 50% allocations to global equity as investors chase yield by allocating to large stocks. Another issue that many investors fail to realize is the inherent risk in bonds. Chasing higher and higher yields means taking more and more credit and liquidity risk. If we see a sudden turnaround in risk appetite, the downside on higher-risk bonds can easily exceed the downside on quality equities.

Brief Summary of Asset Classes Performance in Q1 2015

Some records were broken in Q1. Fifteen year record high on the FTSE 100 (7,037.67) and new record levels on the Dow and S&P were exciting, but the real records and new territory was in the bonds as explained above. History has almost no precedents for this so it is very difficult to understand what will happen next. The Dow and the S&P finished the quarter after hitting their record levels at 18,288.63 and 2,117.39 respectively. We feel this is macro driven of the back of the “divergent” economic theme of a strong USA and weaker rest of the world. Big gains were made in Q1 in European stocks in general and across all the major markets. The place to be invested was in Europe, however not in Euros. So if you had hedged exposure to Europe you would have done excellently in Q1 and we did have this is in our model portfolios. European gains were in the 12% to 18% range for the quarter, which is huge and reflects the expectation that European Quantitative Easing will do the same for Europe as it did for the USA (however, we feel this is over-simplistic as the European political structure differs fundamentally from the USA). Japan also performed well off the back of mixed quantitative messages measuring gains of 9%. Again – in order to enjoy these gains you needed hedged exposure. Emerging markets showed mixed results with many losses resulting from weaker currencies against the all-mighty USD.

Another area of big news in Q1 is currencies – with most currencies experiencing massive losses against the USD. We wrote in our Q3 2014 letter that we thought that “USD was the new gold” as money seeking relative yield moved towards the USD. The strong rally on the USD may possibly be peaking soon as the exporters around the world (excluding USA) now have a substantial price advantage, so there will be some headwinds to further strengthening of the USD. If USA 10yr are yielding 1.94% and European government bonds are yielding zero or negative, then there is an advantage to move further away from Euro towards the USD. This is called a "carry trade" and will work well so long as the USD continues to strengthen – any sudden move on the USD will quickly remove any gains.