Blain’s Morning Porridge – 11th October, 2023: As Always It’s All About Bonds – They Warn of Considerable Risk to Markets

“You can’t swim? Why you crazy? The fall’ll probably kill ya!” 

The threat list to global markets lengthens, but the Truth will be found in the bond markets. Like inflation and rising rates, the effects of a bond market slide are lagging – It’s going to take other financial assets time to catch up on the bond crash!

Apologies for lack of Porridge y’day. My train was cancelled, meaning subsequent ones would likely be full, so I delayed and caught a later one, which was still rammed with people because another train was cancelled. And then it was 20 mins delayed anyway. Then I discover the meeting I was coming in for had been cancelled anyway. So…. I spent what little was left of the Morning glowering at the screen and wondering why I bother with the alarm clock…

Enough whining about Trains – Sir Keir Starmer is going to fix them..

This is not a happy market. Concerns about the brace of bad wars, the threat of further energy driven dislocation (witness the spike in Gas yesterday on news of Finnish pipeline sabotage), and ongoing geopolitical stresses, leave a very bad taste. Reaction to Middle East conflict has been a flight to safe havens. US Treasury 10-yr yields tightened 15 bps Monday– a big move on a day the US bond market was shut. Yet, the curve steepened – suggesting investors see further crisis in the short-term.

I spent most of Monday on calls, and a couple of TV shows, talking through potential scenarios and what we might expect. It was all very snap reactions to an exogenous shock – we came to the conclusion watching how Saudi reacts will be critical. We also recorded a Shard Litebite Podcast on the crisis – you can find it here.

Just a few days after the initial shock and horror, the market is already moving on – back to wondering when Central Banks will ease rates (clue – a while yet). If I wasn’t so gloomy, I would be amused by my colleagues speculating what might happen if things get worse: Blain’s Morning Porridge

• What happens when the lagging effects of rate hikes hit harder in terms of rising sovereign debt fears, damaged corporate credit metrics, while credit card, auto-debt, mortgages, inflation and out-of-control utility bills eviscerate consumers?
• Are markets fully anticipating the pain still to come?
• What happens when wage pressures finally collapse in the face of rising unemployment?
• What happens if inflation continues to rise?
• What happens if we have a full-on energy crisis this winter?
• Is there likely to be a banking crisis on the back of liquidity crisis, or could large scale risk-holders (ie pension, hedge and insurance funds) come a cropper?

My gut-feel is stagflation, pain and financial crisis are very much still on the potential agenda. The latest IMF World Economic Outlook report on the global economy – which reckons the UK will be hit hardest – makes grim reading.

However, as always: the Truth is in Bonds. Watch very carefully what happens next to bond prices. I suspect a deeper capitulation in bonds has been delayed by the current flight to quality triggered by events in Israel.

Bonds form the bedrock of every significant investment account – and to be frank, few folk new to the market these past 20-years really understand just how volatile rates and bonds can interreact to create financial mayhem. Bonds may be boring, but they have the capacity to reset the value and thus price of everything.

Chief Investment Officers across the globe are finally taking notice that bond rates have spiked in line with rising rates… (Quel Surprise!) They suddenly spot the valuation of the government bonds and corporate debt on their portfolios is massively, massively down in price. Dang – how did that happen?

All the textbooks say Bonds should be dull, boring and predictable, and you buy bonds because you don’t lose money on them. Which is true – to a very limited extent.

You don’t lose money on bonds if you hold them to maturity, and they don’t default. But bond prices go up and down to reflect yield and reinvestment. It’s the volatility of prices that is causing all the concern. It goes from a “concern” to crisis when there is a sudden liquidity call – hence our fear about banks who think their hold-to-maturity accounts held for that rainy day are safe as house… If they have to sell – call the regulator.

There is also the effect of bonds on relative prices – higher bond rates mean the price of every other financial asset has to move down so dividend yields reflect their relative value to “risk-free” bonds. Investors need to treat longer dated bonds with extreme caution in periods of instability as FX ructions could still roil rates, triggering bond price swings that could make last year’s Trussterf*ck look like a slow waltz. The longer the bond and lower the coupon, the more dramatically they crash and burn. Without getting geeky about “convexity”, long-dated, low coupon bonds are more sensitive to price changes.

In periods of bond volatility – such as was happening in the current (delayed) capitulation – the Virtuous Sovereign Trinity concept of a stable currency, sustainable bond markets and political competency will be critical if markets become subject to severe tremblors. (And I will write about the Labour conference and ask if they can do better than the current shower later this week.)

I am not convinced younger market participants fear the potential for tough times ahead enough. Some are very brave: they say load up on speculative tech stocks and Long Dated Bonds because they look cheap on the basis Central Banks are bound to cut rates dramatically back to zero if there is crisis, relaunch QE programmes and bail out the markets!

Sweet lord… is there is nothing that can save us from such misplaced youthful enthusiasm and inexperience? 

But, if they are right, then the much derided (yet brilliantly funded) Austria 0.85% Century bond (traded up to 160% and now languishes around 33%) might be the one to buy. Hm.. at that price… is it a good bet? (Probably not. A 100-year bond buying 100 pints of beer today will buy 1.2 beers when it matures due to pernicious inflation…)

I had a discussion with one of my stock picking chums yesterday. He is of the remarkable opinion that Meta (which we all remember as Facebook) is actually a better risk than US treasuries on the basis there is lots of downside to bonds and lots of upside to good tech stocks. I asked him to explain his 6 month view – “well US treasuries will fall and might even default, while Meta might go higher on AI!” (That is why while we send our idiot sons to the Army or Church, while the really “gifted” ones become stockbrokers..)

Actually.. I admit the above paragraph completely somewhat misquotes my buddy who also made some very astute observations about how utility stocks and dull boring predictable stocks are behaving exactly like corporate bonds… Showing the truth of bonds and their effect on relative value on stock prices. An increasing number of stocks are showing bond like predictability.

And never forget… things can always get worse…

Slipping quietly into the news flow on Monday was Robert F Kennedy Jr announcing his withdrawal from the Democratic presidential race, and that’s he’s standing as an independent. That’s bad news if you want predictable, stable, sensible markets. Some folk think Kennedy may only be standing to get Secret Service protection and a spot on any presidential debate to spout his bizarre conspiracy theories, but the reality is – he will fatally split the Democrat vote.

Polls show Biden will lose to Trump in a straight-off election. Trump is Trump, but Biden is just a very old man. Simple as. Up to 23% of Democrat voters would prefer Kennedy to Biden on the Democrat ticket – and 14% would be very likely to back him. If they walk and vote Kennedy, Trump wins. Kennedy will also attract a share of the Trump waverers who might have voted Biden – Conservatives who don’t like Trump and who “won’t pull the lever for him”, might be attracted to the anti-vax, anti-big state, conspiracy-led rhetoric of Kennedy.

All it will take for Biden to lose the US election is a relatively small number of votes in the key marginal seats where the differences in 2020 were a mere 2-4% of the electorate.

Keeping Trump out the White House is a decision for the American voter, but I invite readers to contribute their top Positive and Negative things Donald Trump v2.1 will do for the US and Global Economy. I shall post them later this year.

The events of the last few days has set me thinking about politics and populism – and that’s why I am going to try and post a Second Porridge later this morning on some Lessons from the Israel/Palestine conflict..

No time for five things this morning.

Bill Blain

Strategist – Shard Capital