What do investors want these days? Oh, nothing much. Just an asset that can maintain its value if the global economy gets the heaves, but can also bounce higher if conditions turn out to be better than expected.
Unfortunately, this magical no-downside-all-upside investment doesn’t exist. But people haven’t stopped looking for it.
The hunt for havens has been one of the dominant themes in financial markets over the past year. It has become even more frantic over the past couple of months as the global economy has shown signs of slowing down.
The clearest gauge of the mounting anxiety is bond yields. They have plunged worldwide since the start of the year, a sign that nervous money is pouring into the supposed safety of fixed-income investments. This drives up the prices of bonds. It also drives down their yields.
In many European countries, bond yields are now below zero. Worldwide, the amount of negative-yielding bonds – that is, bonds that are guaranteed to pay you back less than you invested – has soared past US$12.5-trillion. Quite literally, people are signing up to lose money.
Investors clamoured this week to buy a new allotment of Austrian 100-year bonds yielding a puny 1.2 per cent. When people are willing to lend money for a century at rates not much above zero, they are clearly spooked by what lies ahead.
It’s not just bond yields that are delivering this dismal message. The standard havens – utilities stocks, U.S. health-care stocks, gold and Japanese yen – are all enjoying a burst of popularity as people look for safety wherever they can find it. Even bitcoin, which suffered an epic tumble last year, has roared back this year, in part because some investors see it as a refuge from a financial system gone awry.
The flight to caution is understandable if you believe a recession looms ahead. But what makes the current market so hard to fathom is that it’s not delivering a uniform message.
The pessimists who populate the bond market worry that the trade war between the United States and China is strangling commerce. The JPMorgan Global Manufacturing PMI (purchasing managers index), a broad measure of factory activity around the world, has sunk to its lowest level in more than six years. Even more worrisome, parts of the U.S. yield curve are flashing red. The curve – a measure of how short-term bond yields compare with longer-term yields – has inverted its usual shape, a classic sign of a recession ahead.
But despite these concerns, stock investors remain largely upbeat. Their latest surge of optimism has helped drive stock markets in Canada and the United States near record highs. And you can understand why.
The U.S. economy has been strong, thanks in part to the Trump administration’s whopping tax cuts and supersized deficits. U.S. growth has provided a boost to Canada as well.
With unemployment in both countries near half-century lows, and consumer spending strong, it’s hard to imagine a sudden collapse in corporate earnings even as the effect of the Trump tax cuts begins to wane. Stocks also look like a good deal when you consider that the dividend yields on many market indexes now surpass what you could hope to earn from a safe government bond.
The S&P/TSX Composite Index, for instance, offers a dividend yield around 3 per cent, roughly twice what you would earn on a Government of Canada 10-year bond. So long as that math is in place, stock prices are going to enjoy strong support.
All of this sounds plausibly upbeat. The problem is that it’s hard to put too much faith in stock market optimism when the much bigger and usually wiser bond market remains so deeply pessimistic. So what is an investor to do?
A good first step is not to do anything silly. A classic balanced portfolio, split between stocks and bonds, makes sense in this unsettled climate. Holding a larger than usual amount of cash may also be sensible.
What is not so sensible is chasing higher yields by venturing into riskier investments. Until we find out how the stock-bond smackdown will turn out, caution is in order.
That is especially true when it comes to supposed havens. Most are no longer cheap. Many utilities stocks, for instance, are trading near 20 times earnings, an unusually rich valuation for slow-growth power generators, railways and the like. For its part, bitcoin also seems absurdly overvalued given its record of mad volatility. Say what you will about these investments, but they are no longer bargains.
If you insist on betting on something, you may want to gamble on the near certainty that the U.S. Federal Reserve will chop interest rates in coming months. Futures markets are expecting the benchmark fed funds rate to tumble by a percentage point between now and the end of 2020.
Falling U.S. interest rates would make it less attractive for foreigners to hold U.S. bonds, which in turn would drag down the U.S. dollar. One beneficiary of that trend may be gold, which is typically quoted in U.S. dollars. As the greenback becomes cheaper, gold could become more attractive to international investors and their buying may lift gold prices – recently flirting with multi-year highs – even higher.
Emerging market bonds could also have their moment in the sun. They offer attractive yields, and falling U.S. interest rates and a weaker greenback would make them look that much more attractive.
Diversification is key, though. In today’s unsettled environment, no one should think of gold or emerging markets bonds as havens. They’re more like anti-havens – risky assets that could benefit from the deeply conflicted state of financial markets at the moment. Play them if you will, but do so within the context of a broadly diversified portfolio.
Ian McGugan