14 May 2019
The main focus of our thinking is the timing of the next recession. If a recession causes defaults to increase, then owning too many high-yield bonds for too long could be dangerous. At the moment, not many loud alarm bells warning of imminent recession in the US are ringing. But one is: the slope of the yield curve.
When the gap between yields on long-dated (which are usually higher) and short-bonds (usually lower) shrinks to the point that it inverts, we have historically seen a recession nine months or so later. And if we look at 10-year yields relative to two-year yields, we’re not far off that happening again. (Indeed the 10 year-3-month yield part of the curve inverted in March).
US Treasury 10-year yield – 2-year yield (basis points)
Source: Bloomberg a at 31 March 2019
Further, any trade disputes could easily tip the developed world into a recession. At present, President Trump looks to be heading towards making some form of deal with China. The danger is he will regard this as a victory and then turn his fire on Europe. We will see.
More worrying is anaemic growth in Europe. Last year was hardly exciting – but prospects for future growth look paltry at best. Italy is a particular worry. The government continues to spend profusely, even though overall debt levels are dangerously high. Germany, meanwhile, continues to run a budget surplus. This may seem commendable but doesn’t help its neighbours. The German economy is particularly sensitive to global trade so a trade war would severely affect it. Moreover, the decline in demand for cars and new emissions legislation represent real challenges. France is struggling with high taxation and an unsettled electorate. The gilets jaunes protests have been a symptom of this malaise. Growth remains moribund, partly due to high taxes.
European government debt to GDP (%)
Source: Bloomberg as at 31 March 2019
A rough rule of thumb is that when countries’ borrowing relative to their GDP exceeds 100%, it can be the tipping point where they start to struggle to finance themselves. There are exceptions, of course. Japan has a deficit of around 250% of annual GDP. But it has the advantage of being able to print its own currency, a high savings ratio and a balance of payments surplus. Of these positives, Italy only has a high savings ratio. In the short term, it must rely on the European Central Bank to provide QE. We worry that Italy’s debts could again start to worry investors. If that were to occur, US Treasuries would probably perform well.
A recession is perhaps not imminent – in fact central banks have probably extended the economic cycle. But that ‘high-yield’ bonds in Europe are being issued with coupons of less than 3% seems like an oxymoron. Remember that a high-yield bond is defined as one that “may struggle to survive throughout the economic cycle”. So, for us, it seems prudent to reduce our weightings here as we approach the next recession. And with UK political risk so high this almost by default means increasing our weightings to US Treasuries.
The Artemis Strategic Bond Fund therefore retains a higher proportion of government bonds than it has in the past. While not imminent, a recession feels more likely than it once did. Europe has excessive borrowing, especially in certain countries. And when – or if – fear of sovereign defaults in the eurozone increases, investors are likely to hide in US sovereign bonds. We want to be prepared.
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