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How far may we go too far?


MONTHLY INVESTMENT BRIEF 

OCTOBER 2019

 

Laurent Denize

Laurent Denize,
GLOBAL CO-CIO &
GLOBAL HEAD OF FIXED INCOME


Even if it entails tempo-rarily underperformance in our allocation strategies, we will not move one step closer to the cliff.

Central banks have at last achieved one of their objectives: snuffing out rent-seekers. In developed economies, there are no longer any risk-free assets to offer protection from capital erosion. Even in the United States, real yields on 10-year US Treasuries are non-existent and even slightly negative. This has already happened twice in the past decade, in July 2012 and July 2016, but in both instances 10-year yields spiked by more than 150 bps within two years. Ten-year yields are currently about 200 bps below the GDP growth rate. This has never happened in the past 30 years, but let’s be honest, since the implementation of non-conventional tools, real yields have mostly lost their historical ability to predict the real GDP rate.

Either bond investors are right and the U.S. economy will soon enter into recession, or the economy is resilient and bondholders will be in for capital losses that could be as hefty as the gains achieved so far this year. On both sides of the Atlantic, bonds dated longer than 15 years have gained more than 25% on the year to date, which is reminiscent of 2014.

Our scenario is still cautiously optimistic on global growth, which is still being driven by an ongoing wave of consumption. Yes, rising uncertainties have had a significant impact on central banks, which have opted for security over reason through ever more dovish policies. But investors have already priced in this turnabout and are now betting that such measures will actually be stepped up.

This looks like a risky view (especially in the US), and we maintain a degree of caution as regards government bond positions. We don’t want to encourage our investors to stay invested in assets offering real yields that are so far into negative territory. In 10 years or more, the next generation will probably laugh at these investors who lacked simple common sense: “Why on earth did they invest in an asset that guaranteed a loss upon maturity and such severe capital erosion (when including inflation)?”

Why indeed? Greed - as Gordon Gekko would have said? Not really. For many, it is simply a lack of alternatives due to tight regulatory requirements. But for investors who have the choice, we recommend reducing core government bond exposure and rather favouring peripheral bonds and high-quality issuers.

One after another, insurance companies are closing off access to euro-denominated contracts. This shows, if any more evidence were needed, that insurers are no longer able to offer both a capital guarantee and returns without jeopardising their business model.

Even if it entails temporarily underperformance in our allocation strategies, we will not move one step closer to the cliff.

As the French writer Jean Cocteau said: “Tact in audacity consists in knowing how far we may go too far.”

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