This week's stock market drop and wild gyrations may have been wrenching for investors, but they can't really be called a surprise. After 27 months with no significant decline and with many valuation measures signaling caution, a chorus of pundits has been predicting a stock market pullback and higher volatility.
But along with the turmoil, there was a surprise: On Wednesday, the yield on the 10-year United States Treasury note hit 1.85 per cent, its lowest level since May 2013, extending a yearlong Treasury bond market rally that almost no one predicted.
European government bond rates are even lower. The 10-year German bund rates hit 0.715 per cent this week, the lowest in at least 25 years. Ten-year Swiss government bonds fell just below a paltry 0.4 per cent. Ten-year rates in Italy (2.6 per cent) and Spain (2.2 per cent) were only slightly higher than in the United States, which, given the relative weakness of their economies, seems incredible.
The recent volatility of stocks and the unpredictability of interest rates is a potent reminder to most investors to have a diversified mix of stocks and bonds and stick to a simple asset allocation plan. "What happened this week isn't unusual, and it isn't abnormal," said Francis Kinniry, a principal in Vanguard's investment strategy group. "Stocks are a high-risk, high-return asset."
Even though interest rates seem pretty close to rock bottom, some bond experts are saying they could drop even further. "We've been telling our investors for a decade, that just because bond yields are low doesn't mean the direction has to be up," Kinniry said. "A lot of people confuse the level with the direction. We agree the level is low, so return expectations are low. But it's not as simple as gravity, that just because they're low means they have to go up."
This week, some Federal Reserve Board members sounded as if the Fed might delay its long-anticipated rate rise expected in mid-2015. Some economists are even calling for a resumption of its quantitative easing program, the central bank's bond-buying program scheduled to end this month - all moves that could cause rates to drop even further and prolong the bond rally.
Given recent strength in the United States economy, the decline in the unemployment rate and the Fed's repeated intention to tighten monetary policy over the next year, no wonder hardly anyone anticipated this year's bond market rally. But there were a few lonely voices. In his list of "15 Surprises for 2014," issued in January, Douglas Kass, president of Seabreeze Partners Management (and a widely followed market pundit), predicted "slowing global growth" (surprise No. 1); "stock prices decline" (surprise No. 3); and "bonds outperform stocks" (surprise No. 4).
Those have been remarkably accurate so far, though Kass readily acknowledges that he was far too bearish in 2013, when his forecasts were "way off the mark." When I reached him this week at his office in Palm Beach, Florida, Kass said he was sticking by his predictions that stocks would end the year at their lows and that bonds would show a 10 per cent return.
"I think we're approaching an 'aha' moment," he said, "when investors realise that growth isn't going to emerge in the months ahead. The central banks have blunt tools, and they've reached the limit of what they can do. As Peggy Lee put it, 'Is that all there is?' "
Kass expects the bond rally to continue and is among those who suspect the Fed will delay raising rates. "People are losing sight of the fact that the Fed hasn't raised rates since June 2006," he said. "I don't see them raising rates for two or three more years. That will be another surprise for the markets."
Carlo Besenius, chief executive of the financial advisory firm Creative Global Investments, predicted in March that United States and European government bonds would rally, with 10-year Treasury yields falling to 1.8 per cent and German bunds at 0.9 per cent. Both pretty much hit their targets. Although he expects what he calls "a mini-correction" to intervene, he's lowering his target for the next six months even further, to 1.5 per cent for Treasuries and 0.55 per cent for bunds, and deduces the rally will continue.
A major factor in Besenius's forecast is low inflation expectations, even the possibility of deflation in Europe. That helps explains Europe's lower rates, since the real return - the yield minus the inflation rate - reflects very low inflation expectations there. And like Kass, he says he believes the Fed will resume quantitative easing in 2015 and put off any rate increases.
Unlike Kass, Besenius is optimistic about stocks, partly because low bond yields make stocks' expected returns more attractive by comparison. And low global interest rates and falling oil prices should stimulate investment and consumer spending. He sees buying opportunities emerging in the recent sell-off and is predicting a 15 per cent rally from current levels by the end of the year. Investors "should be patient" and "buy into high-yielding sectors like energy, financials, industrials and materials," he said. He also recommends stocks in Brazil, China and India, countries with strong fundamental growth and a potential for monetary easing.
Kinniry said Vanguard had been fielding a surge of calls from investors worried about this week's volatility. Vanguard's two-word message: "Stay cool."
In keeping with its longstanding approach, Vanguard is urging investors to stick to a simple, low-cost asset allocation model divided between stocks and high-quality bonds and not try to time markets. "Many investors make the mistake of looking at bonds as stand-alone investments with low expected returns," he said. "But they're really there to complement the equity risk. We've looked at this in depth over long periods. And when equities are under stress, the only assets with positive returns have been very high-grade government bonds, high-quality municipals and high-grade corporate bonds. Everything else - hedge funds, private equity, real estate, high-yield bonds - has gone down."
©2014 The New York Times News Service
