Bonds are having another great year
There hasn’t been a more shunned investment than bonds in the last decade with central banks all across the world printing money and yields at historical lows. Bonds are defying expectations again and are off to a great start this year. Below I show in orange the actual short-term interest rates compared to the market predicted path of interest rates at the start of each calendar year. Bond yields have not end the year higher than what the markets expected in any of the last 7 years.
I believe the consistent mispricing exists partly because the last time we saw 0% short rates was back in the 1930s and the markets keep expecting a normal recovery when the reality of our growth rate is lower. Our expectations are slowly being pushed down towards reality. Below I show the actual growth rate compared to the IMF estimates at the start of each calendar year.
Slowdown in globalization will be a drag on growth
We are in a world where there simply isn’t enough growth to go around and the easiest way to get growth is to take it from your neighbor through trade wars and competitive devaluations. I believe that prolonged periods of poor growth will likely lead to continued protectionism like the recent Brexit. This becomes a vicious cycle because globalization has been a contributor to global growth in the last half a century and that force may be slowing or reversing. Below I show the growth and recent slowdown in globalization as measured by global trade.
To get a sense of how much globalization contributed to GDP growth, below I run a regression of change in GDP vs. change in global trade. My very rough estimate is that historically we’ve gotten something like a 0.7% annual GDP boost from globalization that may disappear or reverse going forward – we can’t keep increasing our trade as percent of GDP forever. Given that roughly 1.5% of our global GDP growth came from a population growth that is also disappearing, we are looking at a substantial portion that will be missing from the historical 3-4% global growth rate.
Increased likelihood of fat tail events
As I discussed some time ago when the Swiss franc peg was let go, I believe that single political events as well as a few influential central bankers are increasingly dominating market returns. Having the markets be controlled by a few centralized forces means that the outcomes are less likely to be normally distributed and more likely to be binary. This means small margins and movements can make a huge difference in market returns as traders painfully experienced last week. Below I show the distribution of daily returns in developed world stocks and the pound over the last year. Brexit led to a 7 standard deviation loss and an 11 standard deviation loss in the stock and pound markets, respectively.
Gold continues to be a good hedge
I believe gold will continue to be the ideal hedge against a world with slow growth and potential for monetary inflation as central banks look to provide their own economy with a competitive advantage through either devalued currencies or negative yields.
[us_separator]Howard Wang co-authored this article. Howard is a co-founder of Convoy Investments and is responsible for research and portfolio management. Prior to founding Convoy, Howard spent his career in the institutional money management industry, most recently at Bridgewater Associates where he and Robert first met. Howard was part of the investment associates team working with some of the largest and most sophisticated investors in the world, including sovereign wealth funds, pensions, endowments and foundations. Howard received a B.A. in mathematics and economics from Yale University and has been a competitive ballroom dancer for over ten years.
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