June 14, 2015

WORLD: Bond Rout Spells Disaster For Stock Markets As Global Credit Kraken Awakens

The mythical kraken from Clash of the Titans rose out of the sea to destroy people and property.

The Telegraph, UK
written by John Ficenec
Sunday June 14, 2015

Global stock markets are totally unprepared for a return of rising interest rates, and that could lead to a meltdown in equity prices.

Central banks have reached breaking point in their willingness to mindlessly pump money into the markets and soaring bond yields now sound the alarm for a stock market bubble that has reached record highs.

The actions of central bankers after the global financial crisis resulted in record low interest rates and bond markets flooded with money.

Government bond yields promptly fell to record lows around the world. That has resulted in a massive transfer of value from bond holders to equity investors, sending stock markets on a turbo charged run.

Investors who buy bonds earn a fixed level of income for the period they hold the asset. Since the financial crisis investors have seen that level of income collapse.

The UK 10-year government bond has seen its interest payments, or bond yield, more than halve from about 5pc in 2008, to just 2pc at the end of last week.

The desperate search for investment returns during the past six years has also driven corporate bond yields down to record lows, and this in turn makes it much cheaper for companies to borrow.

Companies fund themselves in two ways. One option is by issuing corporate bonds with a fixed interest payment, the other is by issuing shares that pay a dividend that increases in line with profits.

Because companies now have to pay less to their bond holders they can return more to their shareholders and this shift of the share of profits was a factor behind the third longest bull market in history.

There are signs that the transfer of value may be about to reverse with devastating consequences.

A research note from Alan Ruskin, macro strategist at Deutsche Bank, shows that central banks in the US and China are no longer aggressively buying assets. “In sum, 2015 will go down as the year when major Central Banks hit an inflection point in their willingness to distort and manipulate markets,” Mr Ruskin said in the research.

The slowing down of central bank bond buying is already sending shockwaves through the markets.

The global credit kraken has now awoken and government bond yields around the world are beginning to soar.

The yield on German 10-year bonds, a benchmark as one of the safest assets in the world, have risen by more than 1,000pc during the past two months, from a all-time low of 0.075pc in April, to 0.88pc at the end of last week. US Treasury yields have also been on the march higher since the start of the year.

As government and corporate bond yields begin to rise then the cost of borrowing for companies will once again become more expensive. With more profits going to pay interest there will be less available to distribute to those holding the shares. Stock markets are yet to price in this new reality and it could spell disaster for equity investors who were late to the party.

In the UK the FTSE 100 ended last week at 6,794 points, just 4pc off its record April high of 7,104. Across the pond in the US the S&P 500 closed at 2,100 points, only 1pc below the all-time-high of 2,130.8 that was reached only last month.

Professor Robert Shiller’s cyclically adjusted price earnings ratio - or Shiller CAPE - for the S&P 500 is currently at 27, some 63pc above the historic average of 16.6. On only three occasions since 1882 has it been higher – before the 1929 stock market crash, the bursting of the dotcom bubble in 2000 and the banking crisis of 2007.

With stock markets at such highs the returns on offer during the next decade are now incredibly low.

The stock market prices suggest that investors believe both the Federal Reserve and the Bank of England are bluffing about raising interest rates. That may be so, but it is an extremely risky game of chicken for investors to play especially when the potential winnings on offer are so slim.

The risk is that central banks raise rates faster than expected and investors are totally unprepared. Simon French, chief economist at broker Panmure Gordon, has taken an interesting look at how shares perform during a rate tightening cycle.

“We think it prudent to begin positioning for slightly higher rates and the almost inevitable volatility that will accompany the first move,” says Mr French.

Mr French analysed the performance of all stock market sectors during five separate interest rate tightening periods since the mid-1990’s. The best performing sectors were Telecoms and Technology.

So, looking across these sectors then companies such as mobile phone group Vodafone, and accounting software group Sage should hold their own. Bigger telecoms groups like BT should also be able to weather the storm.

The worst performing sectors as interest rates take off were banking and real estate, other areas that underperformed were consumer goods and basic materials.

If the coming rate tightening cycle is anything like the previous ones then companies that might struggle are banks such as Lloyds, RBS, and Standard Chartered. The best returns may also be behind big property groups such as British Land, Land Securities and Great Portland. In the consumer sector then AG Barr, Premier Foods, Tate & Lyle and Associated British Foods will come under pressure. The end of a six year boom for housebuilders will hurt shares in Persimmon, Taylor Wimpey, Redrow, Berkeley and Barratt Developments.

The more industrial shares that are in the firing line would be chemicals groups such as Croda and Carclo, while there will be more pain for miners such as Anglo American, Glencore, BHP Billiton and Rio Tinto.
The other area of the market that is exposed to higher yields are companies that have taken on large amounts of debt. The utility sector is looking rticularly exposed to this problem. Utility shares are usually seen as defensive during a selloff but we would caution about holding companies such as Severn Trent, United Utilities, SSE, or Centrica during the next downturn.

Over the long-term shares will come back but any correction could be very nasty.

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