‘I Know It Sounds Crazy, but It’s True’

Thursday, 13 February 2020
Adelaide, Australia
By Bernd Struben

  • Markets
  • Conservative…or safe?

You’d be forgiven for thinking that nothing can dampen the irrational exuberance driving this bull market.

In the US, the S&P 500 and Dow Jones joined the NASDAQ in closing for new record highs.

The tech dominated NASDAQ is now up 31.1% over the past 12 months. Sans dividends.

The major European indices all closed in the green as well.

And the ASX 200 is up 0.18% at time of writing. That puts it within a whisker of its 22 January all-time high.

Never mind that the coronavirus — optimistically reported to be on the wane just this morning — now appears to be anything but.

This headline, as an example, came from ABC earlier this morning, ‘Investor fears about outbreak ease’. The article notes:

The market optimism came as investor fears about the coronavirus outbreak eased, with reports the pace of its spread had slowed.’

Like me, you may have read something similar over breakfast and felt a glimmer of hope we humans have gotten ahead of this virus. But now…not yet lunchtime…and here’s the latest update on the pandemic from CNBC:

China’s Hubei province reported an additional 242 deaths and 14,840 new cases as of Feb. 12 — a sharp increase from the previous day.

There are also now 50 confirmed cases in Singapore, 15 in Australia and 14 in the US.

Like Australia and most of the developed world, the US is taking the potential for an outbreak seriously. As demonstrated by this headline from The Military Times, ‘US military prepping for coronavirus pandemic’.

The US military may be prepping for a pandemic, but investors won’t have a bar of it.

Nor will the pundits at Domain. They’re forecasting average Australian home prices to increase by 8% this year. Sydney’s meant to lead the charge with 10% price gains. Sydney home price growth is forecast to slow to a ‘meagre’ 6–8% in 2021.

And this with the Australian Bureau of Statistics reporting that the average mortgage people are taking on for existing homes has reached a record $500,000.

No worries though. The mantra goes that the house price surge is going to ‘fuel a broader economic recovery’. Not to mention that the central banks have our backs.

We hope the optimists are right. But we have our doubts.

So, with the stock and housing markets in record territory, this appears an apt time for some words of caution.

More after the markets…


Overnight, the Dow Jones Industrial Average closed up 275.08 points, or 0.94%.

The S&P 500 closed up 21.70 points, or 0.65%.

In Europe the Euro Stoxx 50 index closed up 28.59 points, or 0.75%. Meanwhile, the FTSE 100 gained 0.47%, and Germany’s DAX closed up 121.94 points, or 0.89%.

In Asian markets Japan’s Nikkei 225 is up 14.54 points, or 0.06%. China’s CSI 300 is down 0.13%.

The S&P/ASX 200 is up 13.10 points, or 0.18%.

West Texas Intermediate crude oil is US$51.65 per barrel. Brent crude is US$55.79 per barrel.

Turning to gold, the yellow metal is trading for US$1,566.01 (AU$2,325.53) per troy ounce. Silver is US$17.49 (AU$25.97) per troy ounce.

One bitcoin is worth US$10,372.92.

The Aussie dollar is worth 67.34 US cents.

Conservative…or safe?

Continuing on with today’s theme of vigilance, we turn to a letter from reader Eric. His question is addressed to our wealth preservation expert, Vern Gowdie:

Hello Vern,

I regularly read with great interest your newsletter and articles and support many of your concerns about the economy and the impact of excessive debt.

It would be helpful if you could explain in a future edition why, in a conservative portfolio, (eg 30% cash, 40% bonds (only high investment grade), and the balance in shares and other growth investments), the bonds will not significantly ameliorate the magnitude of the next crash in the share market.

Post GFC, after a few months and in the ensuing 2 years, some similar conservative portfolios only declined about 5%.

I imagine Eric is far from alone in wondering if a diversified conservative portfolio isn’t the best way to make hay while the sun shines and then weather the next market crash. So I forwarded his letter on to Vern.

Below, you can see Vern’s reply in full:

Dear Eric,

Thanks for your thoughtful question.

No two crashes are identical.

What happened with bonds last time, may or may not be repeated.

The following chart of the US 10-year bond (the highest of high investment grade debt) shows a spike in the rate to 4% and then falling away to 1.5% over the next couple of years.

Money Morning

Source: Macro Trends

[Click to open in a new window]

The importance of falling bond rates on fund performance was the topic of the 30 January 2020 Rum Rebellion article I wrote.

The article was written in response to a comment about bond funds returning an average of 10% in the 2019 calendar year:

The following table shows the range of interest rates offered on 10-year Government Bonds by a variety of countries.

Money Morning

Source: Trading Economics

[Click to open in a new window]

Do you notice anything?

Not one of the major countries – US, UK, Germany, Japan and even, Australia – are paying interest rates anywhere near the average generated returns close to 10 per cent.

So how is a near double-digit return possible from such low single-digit rates?

Bond markets are – to the outsider – a back-to-front proposition.

For existing bondholders, if rates go lower than the bond is worth more and if rates go higher, the bond is worth less.

How much higher or lower depends on the duration (term) of the bond and the extent of the interest rate movement.


To help clarify, here’s the difference in interest earned between a 10-year bond paying 1.75% and 0.75%.

Money Morning

Source: Macro Trends

[Click to open in a new window]

If the 10-year rate falls from 1.75% to 0.75%, the holder of the higher paying bond now has an income stream (paying an extra $100k over the life of the bond) that can be sold in the bond market for more than its $1 million face value.

How much more does that 1 per cent rate change make?

Money Morning

Source: CMG Investment Research

[Click to open in a new window]

The table shows the value increases by around 9.6%.

Here’s how bonds generated those impressive returns…

Interest rate of 1.75% PLUS capital gain of 9.6% = 11.35%

What did the US 10-year rate do in 2019?

Glad you asked…it fell around one per cent.

Money Morning

Source: Trading Economics

[Click to open in a new window]

And that’s how you can get a low rate fixed interest investment paying high rate returns.

Again, we have another asset class – fixed interest – that’s been floated higher by central banks suppressing interest rates.

However, what happens if/when there’s a spate of corporate and/or sovereign defaults?

The market panics and demands higher rates.

Remember, when rates rise, bond values fall.

What will be the extent of the losses?

Take a look at the right hand side of the bond return table…the one with the red circles.

Depending upon how high rates go and the duration of the bond (10-year or 30-year), losses could be up to 44% or higher.

After the last crash, falling bond rates provided a significant tailwind to the performance of bond funds.

Hence the funds only declining by 5%.

But will that tailwind happen next time or, if we experience wave after wave of defaults, will the bond market re-price the risk in debt offerings and demand higher rates of return?

If it’s the latter, then bond investors are likely to experience returns somewhere in the range of those in the red circles.

It’s possible the Fed might try to arrest the situation by following the Bank of Japan’s bond market intervention…print money and buy all new government debt and suppress rates.

And they may also do what then ECB has done and buy investment grade corporate debt.

Should this interventionist approach eventuate, then bond yields would most likely fall and we have a repeat of the post-GFC performance.

The near-term (next one to two years) risk with bonds is the market getting nervous about defaults and re-pricing that risk into higher rates.

The higher rates go and the longer the duration of the bond, the greater the losses.

And Europe is giving us a glimpse of what happens to bond returns when rates start to move higher…even modestly.

European bond investors suffering the burden of negative yields came out all right in 2019, thanks to a global surge of central-bank rate cutting. The worry is, that source of returns isn’t shaping up to be nearly as promising for 2020.
WSJ 5 January 2020

While negative rates fell further into the red, the original negative yielding bonds went up in value…I know it sounds crazy, but it’s true.

However, as the prospect of European bond rates going back into the positive looms, those holding negative yielding bonds are facing losses.

The difference between now and 2008/09 is the degree of central bank intervention in suppressing short and long rates.

Until the system is stress tested by a market downturn, no one knows how the dominoes will fall.

If the power of market forces prove to be mightier than the Fed, the potential downside that exists could give investors a very nasty surprise.

In my opinion, why take the capital risk associated with the unknown, when the known — cash in the bank — has virtually no capital risk (provided governments honour their deposit guarantees).

Mine is a ‘bird in the hand’ approach, because next time there may or may not be ‘two in the bush’.