Investors get painful reminder about duration risk

When interest rates fall (there is currently more than $10 trillion in global debt with negative yields), fixed income investors have three choices: 1) accept lower returns, 2) take on more credit risk, aka buy debt in riskier companies, or 3) take more duration risk, aka buy longer-dated securities. Investors have most often opted for the latter, insuring themselves against another downturn despite central bank policies meant to incentivize risk taking. However, because longer-dated bonds are more sensitive to interest rate increases, those investors have also exposed themselves to big losses if things do get better.
 
To make money buying a negative-yielding security, you simply have to sell it at a higher price than you bought it. The strategy has been compared to picking up a dimes in front of a steamroller but since the crisis has been profitable thanks to central banks’ relentless bid. Bonds are meant to be the sleepy portion of the portfolio, the performance stabilizer and volatility dampener. But they have increasingly becoming a destination for speculation (in addition to maintaining price-inelastic passive inflows). Speculators aren’t buying bonds so much for yield but because they can sell them at a higher price to future buyers. That type of behavior, which has been rewarded as lowest-yielding assets have been the best return-generators in recent years, lends itself to the formation of bubbles. When they slide further out on the curve, those speculative bets can become even more dangerous.

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In July, investors were served a painful reminder about duration risk. On July 6, Japan’s 40-year bond yield hit an intraday low of 0.041%, but following the Brexit in just three weeks recovered back to an intraday high of 0.373%. If you bought that 40-year bond at the low yield and sold it this week, you would have lost 24 years-worth of coupon payments. Japan’s 40-year bond would lose another 15% in price if yields simply rose by another 50 basis points to where they stood in March. If yields climbed back to where they started the year, Japan’s 40-year bond would lose a quarter of its value, or 63 years of coupons.
 
Japan is an extreme example because of the massive government-engineered distortions in its financial markets, but the same phenomenon could occur in regard to U.S. treasuries and even dividend stocks like utilities and telecoms, which have smashed their equity market competition this year. If the U.S. 30-year Treasury simply erased its losses for the year, the principal would lose 14% of its value.
 
The rampant demand for long-dated bonds suggests investors are unfamiliar with duration risk or confident the economy will underperform already-low expectations. The post-Brexit stampede into Japanese assets serves as a warning to those willing to step in front of the steamroller.
 
An interesting theory on negative yields
 
Conventional wisdom says interest rates are low because growth and inflation expectations are low. A flattening yield curve is traditionally among the most trusted indicators of an impending recession. However, Tyler Cowen, an economics professor at George Mason and author of the blog Marginal Revolution, offered an interesting contrarian take on that subject this week. He posits that perhaps negative yields are actually a sign of prosperity. Think of safe-haven bonds as insurance policies against economic disasters. As global wealth rises, there will be greater demand to insure that wealth. Demand can grow to levels where investors are even willing to buy bonds at negative interest rates. This is why sovereign bond yields have been steadily falling since 1926 despite intervals of rapid economic growth during that time. While negative interest rates may not make sense at first glance, thinking about negative coupons as fire or earthquake insurance premiums makes them a little easier to stomach.

SLOW GDP GROWTH, RISING WAGES PUT FED IN A PICKLE

The U.S. economy can’t seem to settle on a narrative. Early in the year data suggested growth was accelerating, but a dismal May jobs report, combined with Brexit, brought fleeting expectations of a summer Fed hike to a screeching halt. But volatility cooled and the labor market rebounded impressively in June, causing the Fed last week to once again start making noise about tightening monetary policy. This week, though, another disappointing data point likely puts the central bank on hold until at least December.

U.S. gross domestic product (GDP) grew at an annualized rate of 1.2% in the second quarter, well below consensus estimates of 2.6%. The last two quarters were also revised down. Q1 GDP growth was lowered from 1.1% to 0.8%, while Q4 2015 fell from 1.4% to 0.9% (although total growth for 2016 was revised up two basis points to 2.6%). The 1% growth so far this year is the worst first half performance since 2011.

Personal consumption, which represents nearly 70% of U.S. economic output, remained the strongest component of U.S. GDP, growing 4.2%. However, robust consumer spending was offset by lackluster non-residential fixed business investment, which fell 2.2% and for the third straight quarter. Private inventories were also a major drag on growth, falling for the fifth consecutive quarter and by the most in two years. The lack of business investment reflects the effects of both a stronger dollar and uncertainty in the global economy, despite the survey taking place prior to the Brexit referendum.
 
The GDP report, however, may also not have been quite as disastrous as initially meets the eye. Real final sales, a more accurate depiction of underlying economic momentum, climbed 2.4% in Q2 and are averaging 1.8% growth for the first half of the year. With the destocking inventory adjustment now out of the way, GDP growth should normalize for the rest of the year closer to the new normal of around 2%.
 
In addition, the employment cost index (ECI) continued to show increasing wage pressures as the U.S. labor market nears full employment. Private-sector wages grew 2.6% year-over-year in Q2, the strongest pace in seven years. Strong wage growth should provide upward pressure on inflation, the final piece of the Fed’s puzzle as it looks to normalize rates.
 
On Wednesday the Fed voted almost unanimously to keep rates steady but noted improvement in the economy. The language in the statement was slightly more hawkish than expected, but had little effect on interest rates or the dollar. The greenback and 10-year treasury yield did react to Friday’s GDP print, though, both falling sharply on expectations lingering uncertainty will lead the Federal Open Market Committee (FOMC) to once again err on the side of caution.
 
Early in the year a summer rate hike looked like a forgone conclusion, but inconsistent data derailed those plans. September is being floated as a potential hike meeting, but December looks most likely. If you’ve seen that playbook before it’s because that’s how things went down in 2015 too.

EUROPE TAKES STEPS TO SALVAGE BANKING SYSTEM

The news didn’t get any better in the European banking sector this week. Deutsche Bank (DB) reported earnings (or lack thereof) with net income falling 98% from the year-ago period. Shares in the beleaguered lender are trading at levels not seen since 1976, down almost 50% for the year. Revenue fell year-over-year in four business divisions. While U.S. banks like J.P. Morgan and Citigroup have been able to able resuscitate trading operations, DB saw its sales and trading revenue tumble 23%. Political and economic instability was blamed for the company’s dire fortunes, but those factors show few signs of abating. It also has yet to settle another mortgage probe from the U.S. Department of Justice. Like most banks around the world, the company is trying to rapidly cut costs to meet more stringent capital requirements.
 
Credit Suisse also had a terrible quarter, but one that wasn’t quite as terrible as expected. Its profits only fell 80%! But at least it made a profit. After two straight quarterly losses, massive cost-cutting measures finally started to yield results. However, despite topping rock-bottom expectations, shares traded lower in the aftermath of the report.
 
Santander also saw profits fall amid restructuring and bank fund charges, while Lloyds announced plans to cut 3,000 jobs in a pre-emptive effort to trim costs after Brexit.
 
The media took a nostalgic look at Wall Street’s journey since the financial crisis, with Bloomberg running features about the taming of Wall Street’s bad boy traders and the end of the era of global empire banks
 
For European investors, though, most of the week was spent waiting for Friday night’s release of the latest bank stress tests. In the simulated scenario of a 2018 economic meltdown, most European banks would survive, according to the European Banking Authority, with two notable (and unsurprising) exceptions. Bringing up the rear was the modern world’s oldest bank, Italy’s Monte dei Paschi di Siena (MPS). Banks were expected to a exceed a quality capital-to-total risk-adjusted assets ratio of more than 5.5% to “pass” the test, and MPS came in with a score of minus 2.4%. The only other bank to fall below the threshold was Ireland’s Allied Irish Banks at +4.3%. Among the systemically important European banks, Italy’s Unicredit, Germany’s Deutsche Bank and the U.K.’s Barclays fared the worst with ratios of 7.1%, 7.3% and 7.8%. The results of the test will be used to calculate each bank’s capital requirements later this year.
 
Just before the results were released, the board of Monte dei Paschi took a pre-emptive step, approving a plan to unload 9.2 billion euros in sour loans, mostly to Atlante, a fund put together by the government and financed by Italian banks, insurers and pension funds. With shares trading at less than 10% of book value coming into the day, the company will also try to raise 5 billion euros in new capital (six times its current market capitalization). The stock rallied more than 6% on the news, but is still down more than 80% for the year. Unicredit is said to be mulling a similar makeover.
 
By getting its non-performing loan ratio down from 34% to 18% and hopefully injecting fresh capital, MPS management hopes the company will become an attractive takeover target. Italian Economy Minister Pier Carlo Padoan reportedly expressed “great satisfaction” with the deal, one which Prime Minister Matteo Renzi hopes will restore confidence in the country’s banking system ahead of the make-or-break fall constitutional referendum. Deck chairs have been rearranged, but it remains to be seen whether the Italian banking system can be saved without a painful bailout, which in accordance with E.U. rules would first wipe out junior bondholders, many of whom are unwitting middle-class Italian households.
 
The credibility of the stress test is also in question. With the continent mired in post-Brexit hysteria, the European Banking Authority had little incentive to fail banks and risk triggering further political instability. There are two ways to help a bank meet capital requirements — inject more capital or relax standards. In the wake of the British referendum, regulators have opted for the latter without any credible plan for solving the underlying problem of lackluster growth following a period of irresponsible lending.

TECH SECTOR POSTS BLOCKBUSTER EARNINGS

The changing of the guard in the U.S. economy was on full display this week. While global banks continue to limp along, Silicon Valley is charging full steam ahead.
 
Facebook (FB) once again was the standout. The social networking giant handily beat top and bottom line estimates, growing its revenue by 59% and user base 15% year-over-year. Zuckerberg highlighted the company’s successful push into live video as a source of future growth. Analysts scrambled to raise price targets and the stock rallied more than 5% before paring gains later in the week due in part to a bearish note from short-seller Andrew Left of Citron. He believes the company is vulnerable to competition from the likes of Snapchat, which has a more captive audience with the 18–24 year-old demographic. The company also revealed it could be forced to pay up to $5 billion in back-taxes to the IRS over the transfer of its global operations to Ireland in 2010.
 
Amazon’s (AMZN) quarterly results weren’t far behind. The Seattle-based e-commerce giant grew revenues by 31% and profits by more than 800%, thanks in large part to a booming cloud computing division. While Amazon brought in nearly $18 billion in revenue from its retail business, it was Amazon Web Services, with only $2.89 billion in revenue, that raked in a higher profit. The higher-margin cloud business’ net income of $718 million was up from $305 million year ago. In characteristic fashion, Amazon executives were almost apologetic about the fact the company took home a significant profit. The company prides itself on reinvesting heavily in its business, but doesn’t want you to think the growth story is over. “I would not take our financial results as an indication we’re running out of investment opportunities,” said Amazon CEO Brian Olsavsky.
 
Google (GOOGL) signaled it’s not yet ready to settle into life as a tech dinosaur by also posting a blockbuster quarter. The stock rallied around 4% as the company maintained its dominance over search and advertising, overcoming a$859 million loss on “other bets” in the second quarter.
 
Apple (AAPL) earnings declined as iPhone sales slumped for the second straight quarter, but the stock rallied as the results were better than expected. The company is hardly hurting, with net income of $7.8 billion in the fiscal third quarter, but is struggling to replicate the type of growth that made it the world’s most valuable company. IPhone sales have stalled and Apple has had little success in penetrating the lucrative Chinese market. As the U.S. presidential election heats up, the company is also facing increasing scrutiny over its tax rate. Economist and Hillary Clinton advisor Joseph Stiglitz called Apple’s profit reporting “fraud.” Hey Joe, here’s an idea: how about making U.S. corporate tax policy less prohibitive? 
 
With sovereign bond yields all over the world driven into the ground, both central bankers and investors have slid down the risk spectrum into investment grade corporate credits to meet their respective goals. Look no further than Apple (AAPL) for a demonstration of the dysfunction in global markets. The company has $232 billion on its balance sheet, but around $215 billion of that money is domiciled abroad due to onerous U.S. corporate taxes. The company, struggling to find compelling places to invest its mountain of capital, is instead tapping credit markets to raise money to pay dividends and buyback shares. The company has already issued $15.5 billion worth of bonds this year, and said Thursday it is planning to issue another $5–6 billion. A 10-year Apple bond is expected to yield around 2.5%, the same coupon as a 10-year U.S. treasury note little more than a year ago.
 
In notable earnings outside the tech world, Ford (F) widely missed its profit target and revised down estimates for future growth as auto demand in the U.S. fell sharply. Shares fell more than 10% on the news. The company pointed to increased competition and incentive spending, such as discounts and cheap financing that can stimulate short-term sales but over the long-term undermine profitability.

BRITISH ECONOMY ENJOYS LAST HURRAH BEFORE BREXIT PAIN

The British economy had one last hurrah before the likely Brexit growth shock, growing 0.5% in the second quarter (prior to the referendum). However, the data did little to boost the pound sterling because markets are expecting a rate cut at the next Bank of England (BOE) meeting. In a preview of what’s to come, British retail sales fell at the fastest rate in four years.
 
On the political front, E.U. and U.S. policy officials show no signs of wanting to make life easy for post-Brexit Britain. U.S. trade representative Michael Froman said the U.S. will not consider a bilateral trade deal with the U.K. until it has consummated its split with the E.U. Meanwhile, the European Commission appointed Frenchman Michel Barnier to represent the E.U.’s side in negotiations over the terms of Brexit. Barnier, who led the push for E.U. banking reforms that were unpopular in London, is considered a tough negotiator, with British journalists calling his appointment a declaration of war. Negotiations won’t start until Article 50 is triggered, which is not expected until at least early 2017.
 
At the same time, European officials are doing their best to prevent the Eurozone from further disintegration. E.U. officials decided against hitting Spain and Portugal with fines over their violation of government spending rules. They hope mercy will quell anti-European sentiments, especially in Spain where the separatist movement in Catalonia is stepping up its battle with Madrid.

BANK OF JAPAN (BOJ) HOLDS FIRE

The Bank of Japan (BOJ) has been known to shock markets with massive stimulus packages, but this week the BOJ sprung a surprise in the other direction. The central bank took modest easing action, increasing its purchases of exchange-traded funds (ETFs) but leaving the key interest rate and purchases of government bonds unchanged. Running up against the limits of its monetary policy, BOJ Governor Haruhiko Kuroda appears content to leave the ball in Prime Minister Shinzo Abe’s court. On Wednesday Abe unveiled a $265 billion fiscal stimulus package. The Japanese government is also considering issuance of 50-year bonds for the first time.
 
China looks to be taking its economic deleveraging process more seriously as a crackdown on shadow banking sends shares tumbling. While the People’s Bank of China (PBOC) is sticking to its story that the yuan will remain stable against a basket of global currencies, Chinese buyers continue on an acquisition spree of foreign insurance firms to diversify out of the renminbi.

FURTHER READING

The free press is under attack as Turkey shuts down 16 TV channels, 23 radio stations, 45 daily newspapers, 15 magazines, and 29 publishing houses while detaining dozens of journalists, while China tightens its ban on internet news reporting.
 
Deutsche Boerse gets shareholder approval for London Stock Exchange deal, although regulatory and anti-trust approval, complicated further by Brexit, is still not a sure bet.

Pensions’ face increasing shortfalls as performance woes worsen, and the problem could be even worse than it appears. A popular solution: dump more cash in junk bonds.
 
Yahoo!’s sale to Verizon marks the end of an era for the web pioneer, which now will have to find a home for the assets leftover in the deal.
 
Larry Ellison’s Oracle is set to pay $9.3 billion for cloud-software provider NetSuite, in which Larry Ellison is a 40% stakeholder.
 
SABMiller board backs AB InBev’s higher takeover offer, but activists still aren’t satisfied with the price.
 
Uber backers are said to push for Didi truce in costly war of China ride-hailing market share.
 
Canada GDP shrinks at the fastest rate since 2009 as wildfires crimp oil output.
 
US homeownership hits 50-year low as entry-level buyers are priced out.

Cash-strapped governments enjoy windfall in lower borrowing costs.

Best-paid CEOs run some of worst-performing companies.
 
Brazil’s economic gloom shows signs of lightening.

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