When Bonds Aren’t Bonds Anymore (Digest Summary)

In the aftermath of a severe financial crisis, productive yield opportunities are difficult to find and the conventional tools of efficient diversification and index investing are seemingly pointless. Asset managers must confront a new and discomfiting reality if they want to help savers meet their objectives. History could be a useful guide.

Developed country bond yields have achieved their present nadir on only two previous occasions, both of which were in the wake of severe financial crises. A closer look at previous debacles could inform policymakers of the risks of a premature rate hike and indicate that for the next decade or so, real bond rates will approach zero and equity returns will hover between 4%–6% annually. So great is the scarcity of yield that it poses a threat to investment managers who adopt efficient diversification and passive investing to meet investors’ objectives. The author examines the crises of the 1890s, 1930s, and 2008 to the present to better understand how macroeconomic conditions and policymakers’ responses could inform policy and reshape investment management.

Today’s economy appears to differ substantially from the economies of the 1890s and 1930s. The service sector is much larger, government involvement is much greater, and there is no longer a gold standard. Yet similarities remain in levels of unemployment, industrial production, corporate profits, and credit issuance. Precipitous rises in credit and speculative valuation of at least one major asset class preceded all three crises, as did severe stress on the banking system and credit. Trade and credit linkages led to international contagion. However, because of differences in their magnitude, the 1890s and the recent crisis better fit the mold of a “great recession” rather than a depression, which applies more to the 1930s.

History supports the author’s contention that policy regimes and responses do matter to a macroeconomic recovery. The speed of money and credit contraction in the 1930s led to a failed recovery and back-to-back recessions in that decade. A similar occurrence was evident in the 1890s. These past policy mistakes informed central banks’ and governments’ accommodative responses to the 2008–09 troubles with major financial institutions, underscoring how systemic and far reaching the effects of the crisis were on global economies. Unconventional monetary policy arose from the impossibility to re-regulate, tighten fiscal policy, and stabilize interest rates simultaneously.

Policymakers and investment managers would do well to heed the lessons of history to equip themselves to address the “new normal” of low growth and scant yield.

The author explores the literature on the macroeconomic troubles of the 1890s, 1930s, and the recent Great Recession and compares and contrasts various metrics. He cites data from Thomson Reuters Datastream and Credit Suisse, using graphs to visualize the similar and contrasting trends in US unemployment, industrial production, real corporate earnings, capital market issuance, yield spreads for Latin American and for European periphery countries, US nominal bond yields and real bond returns, and US and UK real equity returns for the time periods following the crises under examination.

He highlights the importance of history for policymakers and governments in formulating policy responses to macroeconomic downturns. Differences in policy regime and reaction translate into different economic outcomes. The depth and severity of the recent recession led policymakers to adopt novel approaches to reinvigorate the economy. Accommodative credit conditions and fiscal policies to address the recent troubles take their inspiration from the 1930s policy mistakes. However, fiscal pro-cyclical tightening in the eurozone in the face of asset outflows and tightening credit put the periphery countries in a similar bind to those on the gold standard in the 1930s. The European Central Bank ultimately eased credit conditions in response to deflationary threats.

The author observes parallels with the 1930s in that inflation has undershot the Fed’s target for several years; there has been a substantial growth in the monetary base and buildup in inventories along with a sharp appreciation of the US dollar in recent months. By contrast, fiscal policy is easing, inventories are decreasing in some sectors, and lower oil prices continue to benefit the economy.

The current fragile recovery has resulted in low bond and equity yields in a manner similar to, yet more volatile than, earlier crises. Equity yields relative to bonds follow the experience of the 1890s quite closely.

The author concludes that great financial shocks lead to secular reflation rather
than stagnation where both short- and long-term interest rates remain below nominal
GDP growth for at least a decade and high-grade bond returns run close to zero or
into negative territory. These circumstances are dire for savers and confront the
asset management profession with the need to find alpha through more active
management of equity, credit and duration risks, and factor investing and through
novel approaches to security selection and portfolio construction.

Policymakers, regulators, money managers, and investors find themselves at an important moment in the investment management profession. Having seemingly exhausted policy responses to jump-start their economies, governments and central banks need to study macroeconomic trends carefully because even small missteps could engender misdirected responses. Although well intended and cost effective, efficient asset allocation and passive investing may not be the solution for a low-yield environment for the foreseeable future. Indeed, present circumstances could encourage a return to fundamental research and active management.