Just buy bonds
Dear friends, dear investors,
When I started my career more than 20 years ago as an economist in the fixed income department of one of European’s largest asset manager, based in Zurich, my boss and mentor used to respond very simply when the CIO would come by and ask about the bond markets: “bonds musch ha!” in this beautiful Swiss German dialect, which in English translates into “just buy bonds”.
While very simplistic in nature, this phrase not only contained a good advice, but was the result of a much more sophisticated analysis (this person successively became head of fixed income at another large European asset manager, such as I have).
Fast forward 22 years and here we are back on stage…well bonds I mean. Yields have now reached levels not seen for more than 15 years in the US, 12 in Europe. We are either in the very last stage of this economic cycle or even perhaps already in recession. All major economic indicators typify the last leg of an economic expansion:
- Central banks have tightened monetary policy, for some very significantly
- Yield curves are either flat or inverted
- Risky assets are expensively valued (e.g. equity risk premia, high yield spreads)
- Inflation is high (although falling)
- Default rates are low but rising and the same holds true for unemployment
On that last point, the US unemployment rate increased from its low of 3.4% in January to 3.9% in October. In the post-World War II era, each time the unemployment rate rose by that amount, either a recession followed or we were already in one. This time may be different, or it may not. I let you chose your side.
Independent from this outcome, another important variable to monitor is money growth. And the outcome is bond-bullish too:
- M2 in the US has been contracting for 10 consecutive months, reaching its lowest level in more than 50 years.
- In Switzerland, M2 is contracting at an unprecedented 13%
- The ECB measure of M2 reached its lowest level in more than 40 years at -2% in September
- Credit growth is taking a hit too. Loans to European households are barely growing while loans to non-financial corporates are contracting. The good news is that monetary policy is working: higher borrowing costs are reducing consumption and investment, while inflation is falling.
All this suggests that central banks are most likely done tightening, economic activity will fall alongside inflation, earnings will contract and default rates will increase while risk premiums will rise.
History suggests that in a late economic cycle, you should be buying duration and moving up in quality. This is what I have done since I joined Weisshorn Asset Management two months ago. The fixed income strategy had successfully been run YTD with a short duration, long credit exposure. Late in October, I have doubled the duration from around 3 to nearly 6 and moved up in quality. This strategy yields 6% in EUR, 7.5% in USD and 3.8% in CHF, which is a very nice place to sit and watch while the normality of monetary policy and economic contraction unfold in front of us.
KEEP IT SIMPLE, just buy bonds.
Alexandre Bouchardy
