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Why the bond bull market could be nearing its end

Tom Stevenson

Tom Stevenson - Investment Director

This article first appeared in the Telegraph

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I graduated in 1985 so my working life has coincided with probably the greatest bond bull market we’ve ever seen. There aren’t many people alive today who think of lending to governments or companies as anything other than a low-risk, if unexciting, form of investment. It’s unsurprising, against that backdrop, that many pension schemes still take their members on a gradual journey out of shares and into bonds and cash as they approach retirement.

As I approach that transition myself, asset allocation is more than just an intellectual exercise. Ahead of what I naturally hope will be a long and healthy third age, the relative performance of the two main asset classes in the years ahead is front of mind. With 35 years on the bull-market clock for bonds and 11 years and counting for shares, neither cycle feels like it has time on its side. But with more than enough tied up in my house, such money as I have accumulated must go into one or the other. I talk a lot here about the outlook for the equity market so I’m going to focus today on what the future holds for fixed income.

To understand the next 35 years, it’s worth looking back over the same period. Why has the time since 1985 been so helpful to bonds? The short answer is the Great Moderation, a remarkable period (2008 aside) of stable growth, falling inflation and interest rates, and infrequent recessions. There are many reasons for this tranquil generation and a half but James Sweeney, an economist at Credit Suisse, recently pointed to two in particular.

First, the global economy has become much less dependent on the production of goods while services have grown in importance. Manufacturing accounts for half as much of US GDP as it did 70 years ago. This matters, because a service economy provides a smoother ride than one focused on making things. Since 1985, only three of nine industrial production slumps have led to a broader recession. Between 1960 and 1984, five out of seven did.

The second key reason for the economy’s lower volatility is a fall in inflation, and particularly in inflation expectations, as an anchoring of the outlook for prices has led to fewer real-world fluctuations. We’ve forgotten what life was like in a volatile inflationary environment, but 40 years ago the expectation of future price rises had a profound influence on real behaviour. Customers front-loaded spending ahead of price hikes. Businesses, meanwhile, built inventories in anticipation of being able to sell at wider margins tomorrow than they could today.

Central banks can take some of the credit for overcoming volatility. But what if the relative tranquillity of the last 35 years, compared with the previous 70, was also due to a lucky confluence of other factors?

What if the Great Moderation was actually a consequence of: no major wars, no global epidemics, no oil shocks, globalisation, falling tariffs, trade growth, more democracy, less superpower rivalry? If the last 35 years were the beneficiary of a one-off set of tailwinds, how easy would it be for these to reverse into headwinds over the next three decades.

Credit Suisse’s Sweeney flags five reasons why the next period may be rather less ‘moderate’ than the last one. First, new forms of conflict pose new problems of deterrence. Cyber warfare is harder to spot than traditional weapons and potentially easier to deploy tactically, without the fear of catastrophic escalation. Attacking power supplies, financial services and elections has the potential to be severely economically disruptive.

Second, climate change, has the potential to damage economic growth but also to interfere with the relationships that bind countries together as and when the consensus about mitigations breaks down, as it has already started to do.

Third, technological change is likely to deepen existing inequalities which have become entrenched during the Great Moderation. We are just starting to experience the economic impact of the populist politics this gap between the haves and have nots is creating.

Fourth, a profound demographic shift as baby boomers retire and the dependency ratio deteriorates will put significant strains on Government finances. The UK’s Debt Management Office is bracing itself for a surge in bond issuance, with March’s Budget likely to provide an early glimpse of a new era of borrow to spend.

Finally, changes in the post-crisis financial plumbing and the end of the road for monetary stimulus pose untested questions about the ability of the financial system to cope with greater volatility, geo-political risks, inflation or the kind of black swan event that the Coronavirus has reminded us can strike at any time.

The Great Moderation and the bond bull market it has facilitated are unlikely to disappear overnight. But greater economic volatility, potentially higher inflation and rising default risks are a longer-term threat to a bond market which has run out of interest-rate road. The Bank of England may or may not shave a quarter point off rates this week but that won’t change the fact that in the UK, Europe and Japan rates can go no lower.

The last 150 years or so has seen three major bond bull markets, in the late Victorian period, the inter-war years and since the Volcker victory over inflation. The extended periods in between have, however, delivered the kind of flat or negative returns that, if repeated, would shatter the complacency that has grown during my working lifetime. I’m not wholly relaxed about the equity markets either, but they are a lot less scary in the medium to long term than fixed income and I have no intention of gliding down to a bond- and cash-heavy retirement pot over the next few years.

Important information: The value of investments and the income from them can go down as well as up, so you may get back less than you invest. Investors should note that the views expressed may no longer be current and may have already been acted upon. There is a risk that the issuers of bonds may not be able to repay the money they have borrowed or make interest payments. When interest rates rise, bonds may fall in value. Rising interest rates may cause the value of your investment to fall. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to an authorised financial adviser.

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