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Financial Industry Insights from Advisors Asset Management
On July 17, 2017
AAM Viewpoints – Rising Global Interest Rates Tracking Global Economic Growth – Higher Inflation Likely
Something began to change in global bond markets in the third week of June. Interest rates began to rise globally in a synchronized way. As far as the yield on the U.S. 10-year Treasury goes, it has risen from a low of 2.12% to 2.38% in a period of roughly two weeks. This is not an insignificant move but one that might not have meant too much if it had happened without other markets moving. Actually, what we have seen are interest rate markets in Europe and Asia moving higher in a synchronous way. We think investors should take note as this could be a tipping point. It is likely a point where asset allocation should be reviewed and adjusted.
Generally, higher interest rates are coincident with periods of economic growth. In fact, we have seen increasing economic growth globally as record low interest rates and a glut of liquidity jump start global GDP growth. This trend is not likely to be a short one. Global central banks have been acting in unison applying record amounts of monetary stimulus for many years. We continue to see leading economic indicators notching sustained expansion numbers. The results are gaining momentum.
There is something else that higher interest rates are highly correlated to and that is inflation. With global central banks targeting higher inflation, it stands to reason that their inflation-friendly policies will lead to the successful achievement of their goal. The quest for inflation creation has been a bit elusive to the central banks. We get drifts of inflation but no trend that appears to have any longevity. We believe that is changing. We believe there is good evidence that rates actually bottomed in 2012 and then again in 2016. This “double bottom” is a generational move and one that has the potential to lead us to decades of higher interest rates and higher inflation.
Source – The Gartman Letter 7-10-17
We believe that investors should take this into consideration when allocating assets to asset classes that may suffer as inflation and interest rates slog higher over time. We saw our first bout of global movement last year as interest rates began their rise off the double bottom. We believe that the reflation trade has many years left on it. Look at how long it has taken central banks to squeeze a couple of percentage points of inflation out of the economy. Remember, central banks have a well-earned reputation for keeping the punchbowl out way too long. Once inflation gets seeded in the economy, it won’t be very easy to stop.
On top of accelerating economic growth increasing the demand for debt, central banks will go from being the biggest buyer of debt to the biggest SELLER of debt. This year the U.S. Federal Reserve (Fed) began discussing their plans to begin reducing their bloated $4.5 trillion balance sheet. Depending on how fast they end up trying to shrink the value of bonds they hold, their actions to sell off bonds will in itself put additional upward pressure on interest rates and downward pressure on bond prices when we consider that the ECB (European Central Bank) and BOJ (Bank of Japan, Japan’s central bank) own hordes of bonds and that they will likely follow the Fed in beginning to contemplate selling off bonds. Even though they will not embark on a plan that they feel will hurt the markets, their task has never been tried before. Jamie Diamond, CEO of JP Morgan, has expressed some very real doubt that the markets will take the shrinking balance sheet without some bumps and bruises.
Much of the investing public is completely unaware of the effects of rising inflation on financial assets. Most of the participants in our financial markets weren’t even in the business the last time we had any sign of inflation, let alone a bond bear market. But the seeds are already planted for these events and we believe it is only a matter of time before the cycle shifts gears. The seeds we refer to are the record inflows into bond funds (see chart above). Investors starved for income and so worried that 2008 is right around the corner have way over allocated their funds to bonds. We think that this might be the bubble that gets very little press.
Source: incrementum
On the other hand, traditional inflation-friendly assets are cheap by historic standards. The chart above shows just how cheap commodities and other real assets are compared to stocks at this time. We think that the skilled investor will be rebalancing into more reflation-friendly asset classes. These classes would include financials, materials, energy, emerging markets, consumer discretionary, healthcare and yes, technology. Areas that we have listed before to under allocate to include utilities, consumer staples, REITs (Real Estate Investment Trusts) and long-dated bonds.
We think that the synchronized move higher in global bond yields is telling us that global GDP is accelerating higher. We note that higher interest rates are not only correlated with higher growth but also higher inflation pressures. The general lack of understanding of inflation dangers with today’s investors leaves many of their portfolios poorly allocated for the coming environment. We believe the secular winds are changing and we believe investors should take heed of the changes.
CRN: 2017-0710-6032R
This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at commentary-disclosures. For additional commentary or financial resources, please visit www.aamlive.com.
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