Bonds, equities and global real estate all look bad investments

Posted on 09 July 2008 with no comments from readers

This title sums up my feelings about investment markets at the moment. It is a bad deal, all round. But what I thought would be useful is to try to explain why this is the case, and the possible lessons that might be learned from this bitter experience. It is, after all, when things are really bad that you should be investing, although very few actually do.

On bonds I am indebted to Professor Niall Ferguson and reading his 2003 book ‘Colossus’ about recent US history. Even then he saw mounting US government spending as the biggest long term problem for the US economy. And the position has got much worse in the five years since. But he could not predict when it might be that the holders of US government bonds would rush for the exit.

‘Bondholders will start to sell off as soon as a critical mass of them recognize that the government’s liabilities are too much, and conclude that the only way it can pay its bills is to print money, leading to higher inflation,’ he counsels in one scenario which he says echoes past events.

‘Few bond traders have history degrees but the high bond yields (which mean low bond prices) of the early 1980s were in large measure a consequence of the inflation of the previous decade.’ He goes on to note that printing money helps governments out of debt by devaluation and by lowering real incomes.

However, US treasury holders are mainly foreign governments with their own domestic economic problems. China holds vast amounts of US bonds but dare not sell off quickly for fear of destabilising its currency. But there has already been a stealthy move by treasury bond holders into other assets, such as the euro and gold that could now gather pace.

In such circumstances a rout in the bond market is perfectly possible. If interest rates have to shoot up to bring down inflation, like in the early 1980s then bond yields will rocket and bond prices will crash.

It should surely also not have escaped the attention of investors that bond yields are just too low in absolute terms. Why should a few per cent per annum be considered a safe haven with inflation raging – particularly in Asian and other emerging markets like the Gulf States and Russia?

The argument must be that if equities crash then bonds will rally, but I have to wonder if that is not already priced into bonds today. They certainly look no bargain and there might be better safe havens available such as precious metals which are inversely correlated to many major asset classes.

On global equity markets I remain resolutely bearish and was bearish before major bourses entered bear market territory, and have not just joined the clamorous crowd in the past week. There are still a few diehard optimists who argue for a quick rebound. But history suggests bear markets take years and not months to play out, and who is to say that this is the market bottom?

Stock markets generally overcorrect to the downside and we have only just entered bear market territory. People also forget that bear markets can last more then a decade, or even a generation. Buying yesterday’s favorite asset class is not usually a successful strategy. It is the next, new big idea you need to find.

That is a neat introduction into real estate. Anybody rushing out to buy a bargain at auction should be committed for insanity. You do not buy in a falling market unless you have no choice. Peak real estate prices around the globe reflected easy credit conditions that no longer exist. Indeed, if you accept my thoughts on inflation and bonds then higher interest rates are still to come, hardly the seeds of a real estate recovery.

Like equities, bear markets in property take years to work through. In the 1990s the UK the market started to fall in early 1991 and bottomed in 1993 but did not seriously pick up until 1997. Personally I think that as the overshoot on the upside was bigger this time, so logically the recovery will take longer.

The real estate cycle, however, does vary a lot more from country to country than equities which are more open to global cash flows. In the UAE house prices are up 78 per cent in the past year, in Russia by over 20 per cent, while the US entered a downturn a year ahead of the UK, Spain and Ireland. But it is notable that the only real estate markets still moving forward in terms of price levels are those driven by high energy prices.

Does that mean that commodities are the place to invest? Most probably yes, but even the commodities boom is getting long in the tooth, and the art is to find the laggards of this major cycle and gain from the final year or two of the major upleg.

It does not take much imagination to see that a position where the rest of the world goes into economic recession – with severe asset price deflation – can not support the commodity producing countries and their booms forever.

Oil is up fifteeen times from its low in 1999, and might conceivably get to $250 next year as Gazprom predicts but that would be a 40 per cent advance from today, not 1,500 per cent. This has been an amazing run up but a lot more of the boom is over than is to come.

Central bankers around the world would love to take the corrective action necessary to bring inflation under control. But I doubt the global economy will be robust enough for higher interest rates anytime soon, and thus a period of high inflation and high commodity prices could linger for a while until the natural corrective forces of recession come into action. This is why an oil price correction might take some time to arrive.

It will be a time of muddling along with global unemployment mounting and asset prices continuing to decline, while general price inflation will be disturbingly high. And in this period sticking to old thought patterns about bond prices, equity rebounds and real estate booms will be a recipie for losing money. In the 1970s cash and precious metals delivered the best returns, and will do so again.