Equities in Dallas - by Elliott Gue
I want to start this week’s issue by wishing readers a very merry Christmas, joyful holiday season and a happy New Year.
Next month, I’ll have some more detailed projections, and investment themes for the year ahead. Today, however, I have just one prediction for you – trading bonds will be exciting in 2024 and, most likely, for years to come. The implications for the stock market are vast.
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For some the words “exciting” and “bonds” may seem at odds – even paradoxical. After all, many think of bonds as downright boring – a low-risk way to generate some income and clip coupons over time.
However, that hasn’t always been the case – perhaps some of you remember it was a far different story back in the 1980s and 1990s.
In fact, when I was an undergraduate economics student at the University of London back in the 90s pretty much all of us were fascinated by the City of London (and Wall Street, in my case). However, it wasn’t equities and the stock market that were the focus of most of the action in those days – it was bonds and fixed income.
We all owned a well-thumbed copy of Liar’s Poker by Michael Lewis. For those of you unfamiliar with the book, it was a semi-autobiographical account detailing the antics and tremendous profits generated by a group of bond traders and salesman at Salomon Brothers back in the late 1980s and early 1990s.
Equities were regarded with scorn – a trading backwater -- at Salomon at that time. Indeed, Lewis recalled that when new Salomon recruits were given jobs at the firm following the training program in New York, the worst possible – the most dreaded – assignment of all was “Equities in Dallas.”
This passage amused my circle of friends so much a call of “Equities in Dallas” became synonymous with doing, or saying, anything regarded as stupid or ill-advised.
And, please, don’t get me wrong or be offended if you happen to hail from Texas or the cities of Dallas and nearby Fort Worth, Texas. As you can imagine, since I’ve followed energy markets closely for almost 25 years, I’ve spent considerable time in both cities in that time and have enjoyed my visits.
However, Dallas was a small, regional office for Salomon in those days and the equity market generated very little revenue for the firm compared to their bread-and-butter of bond sales and trading.
Things have changed – and changed dramatically – in the 15 years since the Great Recession and financial crisis years of 2007-09.
Coming out of that crisis, central banks across the developed world slashed interest rates and embarked on unconventional monetary policy measures like quantitative easing and negative interest rates. Indeed, at one point in December 2020 almost $18.4 trillion – yes, trillion with a “T”—worth of bonds issued by governments around the world paid a negative yield:
Source: Bloomberg
And even in countries like the US where yields never dropped below zero, central banks’ actions squashed volatility in bond markets.
Bank of America’s MOVE Index is similar to the S&P 500 Volatility Index (VIX) but for bonds rather than stocks. Specifically, the MOVE Index tracks volatility priced into options on US interest rate swaps for a basket of 2-year, 5-year, 10-year and 30-year bonds.
Take a look:
Source: Bloomberg
This chart shows the weekly close for the MOVE Index since April 1998; I’ve overlaid the 52-week (1-year) moving average of MOVE in orange to give a better idea of the longer-term trend and filter out some of the week-to-week noise.
As you can see, the average hovered around 100 from the late 1980s through the mid-2000s before collapsing in the 2005-07 period. Indeed, low interest rates and depressed volatility in US fixed income markets in that era helped to inflate the housing bubble that ultimately led to the 2007-09 financial crisis.
Volatility spiked during the Great Recession and financial crisis of 2007-09 before entering a lower for longer environment from 2011 through 2021.
This decade of pay-nothing interest rates (or worse in some cases) and depressed volatility more or less killed trading action in the US bond market and in ETFs tracking bond markets like the iShares 20+Year Treasury ETF (NYSE: TLT), the iShares iBoxx Investment Grade ETF (NYSE: LQD) and even the SPDR Bloomberg High Yield Bond ETF (NYSE: JNK).
And look at this chart:
Source: Bloomberg
As recently as the summer of 2021, the yields on the JNK – an ETF tracking “junk” bonds issued by companies with weaker credit ratings – barely offered a 4% yield while 20+ Year Treasuries in TLT offered around 1.25%.
It’s pretty tough to get excited by yields that low even when inflation was well-contained.
The years of depressed yields and low bond market volatility are now over.
Take a look at my chart above and you’ll see the explosion in bond market volatility, and the BofA Move Index, since 2021 as well as the sharp rise in indicated yields for the JNK, TLT and LQD ETFs all to levels we haven’t seen in over a decade.
The total amount of negative-yielding debt worldwide slipped below $500 billion globally this year for the first time since 2014.
Of course, there are implications for fixed income markets from all this. For individual investors looking to generate income from a portfolio of bonds there are now a plethora of ETFs tracking virtually every corner of the fixed income market. You can buy instant, diversified exposure to “fallen angels,” junk bonds or even emerging market government bonds using a US-traded ETF fund.
And with yields no longer depressed across-the-board, there’s real value in actively managing your exposure to different parts of the fixed income market.
Listen to the mainstream media and you might suppose 2023 has been a terrible year for fixed income investors thanks to Fed policy. Certainly, the stock market has been the place to be since the end of October, right?
However, dig a little deeper and you’ll find plenty of pockets of strength; for example, the Invesco Emerging Markets Sovereign Debt ETF (NYSE: PCY) is beating the S&P 500 since the end of October, offers a 6.74% yield and has a fraction of the volatility of the stock market.
Just as important: The implications for the stock and commodity markets.
You see, markets just don’t function well when the cost of money is artificially depressed.
Ultra-low interest rates favor growth sectors, driving money into sectors and stocks with limited near-term earnings but plenty of long-term potential. That’s arguably the most powerful force behind the rise of the Magnificent 7 cadre of technology and growth stocks at the expense of most other market sectors.
And depressed bond yields will also tend to favor larger businesses with more ready access to capital markets over small businesses that depend on bank loans to fund growth.
If you believe, as I do, the brief spell of ultra-low rates and depressed bond market volatility ahead of the financial crisis years of 2007-09 helped inflate the residential real estate and credit bubble of that era, imagine the market dislocations and bubbles inflated by the decade of financial repression from 2011 to 2021!
In Europe, negative interest rates clearly acted as a pernicious “tax” on the banking system, helping starve the region’s economies of capital and the flow of credit needed to grow.
As we enter 2024, I believe we’re only seeing the tip of the proverbial iceberg in terms of implications for the stock market. Indeed, the new era of (at a minimum) significant, positive yields is likely to contribute to a rotation in market leadership.
In addition, the US market, buoyed by its hefty tech exposure, has dominated equity market returns for the past 15 years. The end of free money could well grant emerging markets, and laggard developed markets like Europe and Japan, their day in the Sun.
At a minimum, I’ve written more about the credit and bond markets over the past 12 months than at any other time in the past decade – I don’t expect that to change any time soon.
I have received numerous requests from readers for more information on bond exchange traded funds (ETFs) beyond the names already recommended and covered in the model portfolio. So, next month I’ll be initiating coverage of a long list of fixed income and bond ETFs as part of a detailed downloadable report that will be a feature of the paid tier of The Free Market Speculator.
If you’re not already a member of paid tier of The Free Market Speculator and would like to gain access to my model portfolio and upcoming fixed income ETF report, there are just a few days left on my 90-day free trial offer.
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