Despite optimism for the global economy and the majority of the FTSE 100 company’s exposure to that, the index continues to languish. Wednesday’s fall in the FTSE 100, in contrast to Europe and the US, was a reaction to the rise in sterling on the back of what appears to be some optimism on Brexit from European negotiators. The reaction was slightly strange as the FTSE had not exactly been a stellar performer during the extended period of sterling weakness.
The problem for many seasoned investors is trying to make rational decisions when the traditional investment models provide no logic. Many believe as a consequence of central bank policy. We have, on more than one occasion, pointed out that German 10-year bunds yielding 0.4% against leading German equities yielding 3.5% defies traditional valuations. Anyone who buys a German bund yielding 50 basis points must lose money in real terms if the ECB manages to keep inflation at the target of 2% over the same period of time. A list of FTSE 100 companies yielding more than 5%, Rio, Vodafone, National Grid and Imperial Tobacco to name but a few when 10-year gilts offer you not much more than 1.3%, again does not follow historic norms.
Bond guru Bill Gross, who has made his name through an extended bull market in bonds, a classic case of being in the right place at the time, but then having the brains to realise it has suffered large number redemptions during the past year due to his performance. His Janus fund has underperformed by around 8% over 1 and 3 years. Investors have withdrawn almost a billion dollars from his fund. The underperformance has apparently partly come from his expectation that a near thirty-year gap between the yield on German bunds and US Treasuries will narrow. A trade based on the expectation that yields will revert towards the mean. In theory that trade will make you short the US dollar and long the euro, adding to the pain.
10-year gilt yields averaged over 5% from 1995 through to 2009, in that time leading UK equities roughly half that on average. It is barely worth considering the pain reverting to that mean would cause to UK investors in both asset classes.
US markets are closer to historic norms as they try to raise interest rates, but at close to 3% US ten-year Treasury yields remain well below historic levels. The bull market in bonds has lasted almost 40 years as central banks have focussed on targeting inflation rates. In theory, if the level of debt now created in the world means government bond yields remain close to where they are, could we have a 40-year equity bull market?
Bill Gross will probably be right one day, those who have the patience may well reap the rewards. Eventually, historic norms will reassert themselves, quite how and when it will happen is anyone’s guess. In the meantime, as the saying goes markets can stay irrational longer than investors can stay solvent.