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If a bull market ends does a bear market start? The question is worth asking because it rather looks like the great bull bond bull market is over.
The key thing to remember here (with apologies to bond market experts) is that bond prices go up when interest rates go down — and that interest rates tend to go down when inflation goes down. For the past 40 years or so this has been the main dynamic in the market. Falling inflation, falling rates, rising bond prices. Fortunes have been made.
But something has very obviously changed. Inflation is rising. The latest numbers in the UK put it at 3.2 per cent (the Bank of England’s target is 2 per cent) and it is no longer considered completely nuts to talk of it hitting 4 per cent before the year is out.
You can argue that this is transitory, but it has already persisted for rather a long time, for something as temporary as the world’s central banks insist it is. That suggests that it is well on time for the whole thing to reverse. Rising inflation, rising interest rates, falling bond prices.
If so, you will want to get out of the bond market as fast as you can. But here’s the thing: the end of a bull market, in either bonds or equities, doesn’t necessarily mean that a bear market will immediately follow.
Look to the Japanese government bond market as an example. Yields started to fall sharply in the early 1990s, from around 8 per cent to more like 2 per cent. During that decade the annual return (including the yield and the capital return) came in at 9.8 per cent (this was the time to make real money).
From 1999 to 2017 yields had less far to fall — they meandered between just over 0 and 2 per cent before slipping briefly below zero in 2016. The average annual total return in those years was 2.2 per cent. Since then yields have bumped boringly along the bottom. Average annual total return? 0.3 per cent. Not a bull market, but not exactly a bear market either.
Obviously it’s different in the UK at the moment. Japan has managed very little of the kind of inflation that drives central bankers to raise interest rates. The UK has lots of it. It would be a fair assumption that this would make the difference. But again, it isn’t necessarily so.
It’s perfectly possible for central banks to decide they don’t want rates to rise with inflation and to cap the yields on the bonds they issue. When the second world war broke out US bonds were just coming to the end of a 25 year bull market. Inflation was rising (as it almost always does in wartime).
But between 1942 and 1951 the US Treasury and Federal Reserve worked to stop yields on the 10-year bond rising above 2.5 per cent and (for a shorter period) to stop the yield on three-month Treasury bills rising above three-eighths of a per cent. They did this by buying large numbers of their own bonds in the open market (this pushed the bond price up and the yield on them down).
They kept doing it even as inflation soared: by 1948 US inflation, driven by pent-up demand, supply shortages and the 149 per cent rise in the monetary base in a decade (sound familiar?) peaked at just over 20 per cent.
My point is that there are a variety of things that can happen from here. Inflation could turn out to be transient, in which case we could be Japan (all the money has been made, but a real bear doesn’t start). Inflation could rise, in which case we could see rates rise fast and bond prices collapse. Or we could be the US in the second world war — high inflation but low interest rates, or at least interest rates kept well below inflation, nonetheless.
The latter is most likely. Why? For the same reason it was then — debt. The US government needed to keep rates low so it could borrow cheaply to finance the war. Most governments need to keep rates low to finance their ridiculous deficits.
You can get a two-year fixed rate mortgage in the UK at the moment at just under 1 per cent. If that went to 3.2 per cent (the most recent CPI in the UK) your monthly payments on £250,000 would jump from £935 to £1,212. Now imagine owing £2,224.5bn and rising (as our government does). To sort ourselves out, we need to erode the value of all debt.
You get the point — there is a reason why we are already creating an awful lot of money to buy an awful lot of government securities to keep bond prices high and yields down (this is what QE does) even as inflation rises.
There is lots to argue with in what I have said here. But the core point is that there is no reason for you to hold government bonds, unless you have to (the government would like you to stay in government bonds so this is something to watch). If your best-case scenario is not much return and your worst is losing a lot of money, there is surely somewhere better to be.
This brings us to the tricky bit — where is that? Equities are part of the answer, of course. The UK market is both undervalued and high yielding. But you need the diversification that bonds once bought you. Waverton’s Luke Hyde Smith suggests a few ideas (which the firm puts into practice in its Waverton Real Assets Fund) including holding a portfolio of supermarkets via the Supermarket Income Reit, which offers a yield of nearly 5 per cent covered by long dated and inflation-linked cash flows. Otherwise, commodities will serve you well in inflationary times.
It is also worth looking to a new launch fund from Ruffer, a fund manager company which is very much convinced that the old world of allocating 60 per cent of a portfolio to equity and 40 per cent to bonds is dead, dead, dead.
You can already get access to its portfolios via Ruffer Investment Company (which I hold) and Ruffer Total Return Fund. But their new one — the Ruffer Diversified Return Fund — is more accessible than the second (it will be on more platforms and can be bought and sold daily) and does not come with the premium of the first (shares in which are currently trading at a 2.5 per cent premium to net asset value).
If you want a portfolio run by managers who are as convinced as I am that we are on the edge of a major regime change in markets — and who have the experience to protect you from it — this is one place to look.