Bonds, Who Needs Em?

1350 words – a 4 minute read.

Here at TPWA we have been deeply UW bonds all year. Over the past Q or so we have switched roughly half of our bond position to that other big, growing bond mkt across the Pacific, the Chinese bond market, which offers a normal looking yield curve, near 3% 10 yr. rates & a badly beaten up corporate credit market post Evergrande etc. More on China below.

BofA notes that 2021 is shaping up as the worst year since 1949 for World Govt Bond Indices. This creates a great set up for active global macro multi asset investors like TPWA – if your global macro fund isn’t doing well this year give us a call. 

 History notes that 1950 was barely positive and 1951 was another negative return year. In other words, a multi-year bear market, which is exactly where I think we are today – in the early innings of a DM Govt bond bear market.

 JPM notes that the global DM yield curve (10-30 yr.) is the flattest since GFC while real rates in many countries are at record lows including US, UK, Germany. Notwithstanding this poor performance, unappealing current state & very questionable outlook, plenty of folks DO want bonds with near insatiable demand for long duration yielding assets from pensions (rebalancing) banks and insurance companies.

 On the supply side, Pineridge notes that ytd net new UST issuance available for private purchasers was just north of $100B which certainly helps explain why the 30 yr. UST bond struggles to stay above 2% when core inflation is running at 4%. It also provides some color on all the news around PE shops & private credit.

 Its interesting to note that Paul Krugman’s most recent article argues that the current US inflation scare is more akin to that same late 1940s, early 1950s period than to the 1970s. Krugman notes that US real gross domestic demand is running 2% below pre pandemic trend, highlighting the switch from services to goods as the main cause for what he expects to be a temporary inflation push. Notwithstanding all the media hype, an October Gallup poll found only 5% see inflation as a top problem today vs 10-50% back in the 70s.

I see two key points. One, deeply negative real yields support risk assets. Stocks have a hard enough time going down big with EPS growth of 40% + which is what JPM has for both the US and EU in Q3. In addition, 65% of US companies changing guidance have lifted it, best % in 4 years.

Add deeply negative real yields & your twin engine US equity market sets records day after day, as negative real yields support long duration, big cap tech while inflation pushes folks into cyclicals like energy & financials. Given this real yield environment, our TPWA model portfolio bet is on thematics vs FANGs, given both are supported by negative real yields; year to date thematics are significantly OPing. 

As a buddy recently said, this is tough stuff to wrap one’s head around but it seems important to do so. Limited UST supply and strong demand coupled with above trend inflation suggests a gradual uptrend in long rates, continued negative real rates and hence a decent ongoing environment for risk assets. 

Here is the 2nd key point. The current FI structure suggests very little buy in to my medium term (2021-2025) bull case of above average growth & above trend inflation driven by a cap ex boom & productivity surge a la 1995-1999.  In essence, the FI market is betting on a return to the post GFC growth path of 2% growth and 1-2% inflation.

 My view remains above average US growth of around 3-4% and above trend inflation of 2-3% over the 2022-2025 period. The market is too aggressive on inflation in the short term and not aggressive enough on the medium term. Thus, the current 81% chance of 3, yes, 3 Fed rate hikes next year will prove way off the mark though the Fed may well speed up taper in December as a nod to the inflationistas.

 The pieces are falling into place for 2022 -2025 to be better than expected – another cap ex/productivity angle is the growing focus on global production footprints split on a 30/40/30 regional basis. While much of this driven by supply chain concerns & climate focus around carbon in both production and transportation, it also deepens the opportunity set for IoT interoperability. The Tri Polar World framework continues to manifest itself.

 One question before we switch gears: Will the inflation scare turn out to be the upside USD lever? With DXY at 95 it is starting to look that way which is not my view…Count me as a worried skeptic.

 A couple of final thoughts on the two Cs; China and Climate. China’s growth slowdown is likely for real – JPM now sees 4.7% growth in 2022, with a stable RMB as lockdowns support the current account. China is trying to thread the needle between slowing the local Govt debt buildup and excessive slowing of the economy.

 Near term things are starting to look up: China’s October M2 growth at almost 9% y/y was best since March, while the property market tone is improving with stocks up sharply this week for the best rally in 16 months.

 This week’s earnings by Tencent and others were a great Let Mr. Market tell me moment: Tencent’s revenue growth of 13% was the lowest since it came public 17 years ago… headlines were deeply negative… so what did KWEB do (China Internet ETF w Tencent as #1 position)? It rallied & is now up 15% or so since its bottom 3 months ago – yes 3 months ago. As previously noted, folks have had every reason to sell China and they have. Now its buy time with KWEB still down 50% from its 52 week high.

 As discussed in last week’s Musings, China is likely on a glide path thru 2022. The just concluded Central Committee meeting reinforcing Pres. Xi’s chances for a 3rd term a year from now suggests exactly that.

 After looking like a sea of volatility last summer, China now offers an oasis of calm with the tough policy choices made, policy quiver full, Pres. Xi’s 3rd term already with the nod; cheap, bombed out & deeply unloved Chinese financial assets could provide some of 2022’s best returns.

 We have maintained our China equity exposure & as noted above, like both Chinese Govt and corporate debt. We feel very comfortable w RMB exposure and amply compensated w roughly 10% USD Yields in our HY position.

On Climate, COP26 is winding up while we wait to learn whether a global carbon market will be agreed to; investors are optimistic with KRBN and other carbon plays hitting new highs. China – US climate cooperation is a real plus as is China’s statement that it plans to build 150 nuclear reactors over the coming 15 years which gave URNM a nice lift.

 Work suggests that the net cost to transition to net zero is roughly 1% of US GDP pa for a decade, roughly the same spending pace that helped develop the Internet in the 2nd H of the 1990s… Steve Blitz over at Lombard notes the recent patent surge is akin to that seen in the early 1990s which helped set off the cap ex inspired productivity boom in the 2nd H of the 90s. ARK highlights that a combination of software and hardware improvements is cutting the cost of AI training in half every 9 months, a rate of decline it expects to hold for the next decade, implying ever better AI as training rounds accelerate.

Thus, the 1995-1999 analogue for the 2021-2025 period continues to really resonate with me… do you agree? Biden’s human infrastructure plan will provide further support – lets see if it gets done.   

Along these same lines, please enjoy this article on Apple’s new microprocessor as an example of our recently introduced Analytical Speed construct.