As I write this short blog (late on Monday 12th February 2018), the major US and UK markets are rebounding nicely after a week or so of mayhem. The obvious question is whether this is a proper rebound (proceeded by a bump) or whether we’ve got much to come (implying this is the start of a rout)? My own sense is that nothing is really answered by the events of the last few days. The panic has not been so intense that it’s encouraged the central bankers to whisper soft words. Equally, we’ve not seen any real evidence that the “authorities” are overly alarmed – apart from the odd Trump tweet. If we are to assume this is a warning shot by investors, worried by inflation, then I think we might be in for some more turbulence – the authorities need to listen, learn and act! My own complete guess is that we’ll see another proper push downwards in the next few days. I stick by my guestimate that we won’t see a proper correction until the FTSE goes below 7000 and the S&P below 2400. The catalyst? Bond yields.
Most of us tend to fixate on round numbers. Take long-term investment returns from risky assets. A huge variety of research studies have shown that most of us expect returns of around 6 to 7% per annum over the long term from investing in equities. It’s a similar story for dividend yields from equities. Most of us have an instinctive understanding of what constitutes a poor yield – under 2% – and what constitutes an attractive yield – anything above 3.5%. It won’t come as a great surprise to learn that bond investors also have ‘magic numbers’ which they think constitutes an important signaling mechanism.
The yield on US Treasury bonds is one such example. Most assume that anything above 2.5% for ten-year govies constitutes an important turning point while anything above 3% strikes most as a big flashing red light. One investment bank recently headlined an email to investors with “is there life at a US Treasury yield of 3%” – with the implication being that any yield above 3% implies that equities might steadily collapse in value. The chart below shows that those concerns are bound to grow over the next weeks and months – yields look they are set for a challenge at 3%.
But a recent note from analysts at Cross Border Capital does also give us some historical perspective – they have a fab chart which shows G4 yields (UK, US, Japan and Eurozone) over the last thirty plus years. The current upturn barely amounts to more than a tiny uptick compared to long-term averages. If bond investors are worried about rising yields, their worries only just started if history is anything to go by. Overall though the prognosis is grim for bonds. Cross Border reckons global bond markets will suffer a “tough 2018, with G4 markets losing an average 5-6%, and with losses concentrated in US Treasuries and JGBs…. We continue to expect 10- year bonds to test 3.5% yields this year”. If Cross Border is right, expect more stock market volatility as first that 3% UST yield barrier is breached and then 3.5%. I think Cross Border are spot on. We’ll see UKTs hit 3.5% within a few months, kicking off the next bout of market volatility.
Nevertheless, I’m also completely willing to accept that I’m possibly a little too bearish in the immediate near future – two interesting notes from investors makes me think this could be the start of a proper rebound.
The first is from Robin Milway of Arbrook Investors who has just launched his new Arbrook/G10 American Equities Fund. According to Robin “over the last 30 years, the median drawdown lasts 17 days and takes the market down 9%. This one is 10 days in. Once a drawdown has ended the market tends to recover quickly, recovering half the losses in 2 weeks, and then it takes 2 months more for the market to fully recover and drawdown damage is never permanent”. Robin also features the chart below as an excellent historical summary of sell-offs. The bottom line is that each correction is usually about 7% with a 68% gain 60 months later.
The next chart is from analysts at Deutsche Asset management. It riffs on the same theme as Milway. According to Deutsche by historic standards, the recent drawdown of 7.8% in the S&P 500 does not look all that remarkable. They’ve also looked at maximum drawdowns for their ‘chart of the week’. For Deutsche “ maximum drawdowns measure the loss if you buy at the latest peak before a market decline, and sell just as the market starts recovering again. For this chart, we set 1% as the hurdle rate of when a trend turns and simply looked for the highest maximum drawdown for each year. As our chart shows, so far, 2018 has been bang in line with long-term trends. Instead, what was unusual was the exceptionally small maximum drawdown in 2017, which followed on the heels of several years of relative calm”. For more on Deutsche’s thinking have a look at their CIO Flash “Back to normality”.