Bond bubble

Considering the uncertain macro outlook, or top-down view of equities, the flight to the safety of risk-free bonds has been both stunning and unprecedented. In Australia, domestic bond yields have fallen to 50-year lows. In this regard the yield on the two-year government bond fell to 3.095% on Friday, November 21, the lowest level since the 1950s. In addition, the yields on the three and five-year bonds crashed to 3.44% and 3.76% respectively, which represent all-time lows since records began.
Despite a 50% correction, are government long bonds yielding 3% unfranked better than fully franked equity dividend yield? I certainly don't think so.

Investors can take out a five-year fixed loan from a bank, claim the deductible interest and buy their own high fully franked yield shares with the loan because I am betting that the return will be better than 3.44% unfranked per year over five years! In other words, equity yield appears grossly cheaper than bond yield.

As a result, with a 2008-09 price/earnings (P/E) multiple of about 8.5 times, the current earnings yield for the Australian equity market is nearly 11.76%, which represents an equity risk premium of exactly 800 basis points on five-year bonds. I acknowledge the risk to earnings remains high – valuations are already factoring in doomsday scenarios of nearly 45% earnings declines for industrials – but this scenario is highly unlikely across the broader market.

Of course, the dramatic fall in domestic bond yields highlight both the forecast weakness in the economy and the expectation that the Reserve Bank will continue to aggressively cut interest rates. As a result, bank bill futures are currently implying a cash rate of 3.25% by the middle of next year or a 400 basis point reduction from the beginning of September. Just as equities reached extreme overvaluation levels last year, bonds will prove to be no different in 2009.

The bears will argue that the flipside of significantly lower bond yields is the prospect a deep domestic recession. However the Reserve Bank and Treasury don't share that view. While acknowledging the prospect of weakness, in recent public submissions both the Treasury and the Reserve expect the economy will just sustain positive growth and avoid a severe recession. In addition, while the Reserve expects inflation pressures to fall next year, recent comments confirm inflationary pressures are forecast to remain moderately high. Strange days indeed.

If the Reserve Bank and the Treasury are correct and there is no domestic recession, Australian long bonds will be extremely overvalued next year. Consequently, while it is difficult to determine whether equities have bottomed, they remain clearly extremely undervalued relative to bonds.

The level of domestic government bond yields merely reflects overseas trends. In the same trend, the flight from equities into the safety of US Treasury Bills has been amazing. The following chart shows the premium for US bonds over other fixed income assets, and equities as an asset class, has reached historic highs.

Comparing this market with past recessions, global equities are factoring in the worst economic downturn since the Great Depression.

Therefore, valuations remain extremely attractive and equities are undergoing a bottoming process. Last week's meltdown has further undermined investor sentiment. Consequently, considering global equity markets continue to record new lows, it appears that this bottoming process may become extended.

It is vital that world equity markets establish a basing formation over the course of the next few months in order for an improvement in investor sentiment, which remains at record lows. Otherwise the bottoming process will become protracted until next year when the US presidential inauguration will become a positive inflection point for financial markets.

In the meantime, I continue to urge investors to accumulate high-quality companies with strong balance sheets on any market pull-backs, considering the emergence of extreme long-term undervaluation levels for domestic equities.

January 20 can't come fast enough

In addition, it appears that the uncertain macro factors are complicated by US political issues. It is worth noting that since the US Treasury decided to reject buying any further mortgage-backed securities under the $US700 billion TARP facility, the S&P financials have fallen 30%.There appears little doubt that this political uncertainty has directly led to the most recent meltdown last week.

In the same context, the inability of the G20 meeting to formulate any concrete economic strategies led to further weakness in global equities. In both cases I believe the main reason was undoubtedly the uncertainty of the current leadership vacuum in US politics. In this respect it was interesting to observe the very positive reaction to the appointment of Timothy Geithner, currently the New York Fed president, to replace Henry Paulson as the Treasury Secretary. Geithner is highly regarded in his current role and through his active participation in the financial restructuring of the US financial industry in the aftermath of the subprime loan meltdown.

The resounding win by the Democrats has delivered Barack Obama a strong mandate for change and a unique opportunity. In this regard, the incoming President is not only viewed as a man for all Americans but a US politician more popular with global leaders due to his greater understanding of world issues. Therefore, we expect a more concerted and synchronised global approach to the current world financial crisis after his inauguration.

In addition, being a keen student of history, it is almost certain that the new US leader will implement a very large $US250–300 billion fiscal stimulus equivalent to Franklin Roosevelt's 'New Deal’. There is no doubt history reveals that while dramatic easings in monetary policy play a vital role in any recovery process, a supplementary strong fiscal response is an equally important factor. The inauguration of the new President occurs on January 20 and I believe equity markets will view the transfer of power as a very positive catalyst for an acceleration in the recovery process.

While on the subject of fiscal stimulus, it is interesting to observe the subsequent market reaction to the recent $US586 billion Chinese economic stimulus package. While I believed about a third of the stimulus package was new spending initiatives, I regarded the key takeaway as the strong commitment of Chinese government to reviving economic growth back to the 8% target level.

However, the consensus view at the time appeared to dismiss the Chinese initiatives as opportunistic ahead of the G20 meeting. As a result, the stimulus was paid scant regard and largely dismissed by analysts. The market reaction has been very different. Since the announcement, the Chinese equity market has outperformed by 27%, with Shanghai up by 15% while the S&P500 has fallen by 12%. While the sceptics remain dismissive, the rally might just be reflective of the early stages of the next stage for China or the shift from an export-based economy to a more consumer-based one.

Bonds appear to be the new bubble. My long-held view is the true "defensiveness" of an asset is a function of the price paid for that asset, not mere the perceived defensiveness of its structure. Bonds appear grossly expensive relative to all other asset classes right now and the last thing I would be putting money into is a government bond at a 50-year low yield. Be a little braver people; it’s high-quality, long-duration equities you should be buying.

Charlie Aitken, the head of institutional dealing at Southern Cross Equities, may have interests in any of the stocks mentioned.