The Path of Least Resistance

October has been a grizzly month for stock and bond markets, the latter in particular.

The reasons for this rout in the USA are well rehearsed. Foremost is the now generally accepted fact that bond market vigilantes are back in the driving seat, even so far as influencing much of the rhetoric emanating from the leading central banks around the world. Jerome Powell recently intimated that the bond markets are doing the central bank’s work for them. Deutsche Bank have estimated that the rise in US long bond yields equates to three Federal Reserve interest rate hikes that amount to 0.75 per cent. Any vestiges of the discussion of whether bond prices affect share prices, upwards or downwards, have disappeared as the correlation is there for all investors to see. Good economic news is bad news for bond and share prices, and vice versa. What is good for Main Street is bad for Wall Street. This applies across the international financial markets (but is nothing new).

Annual GDP numbers in the USA for the third quarter of the current year have come out at 4.9 per cent annualised, far exceeding expectations, even as inflation remains subdued. This demonstrates the feel-good factor among American consumers who represent the biggest slice of GDP. Nonetheless, excess savings accumulated from the pandemic have largely been drawn down and this is expected to become visible in the months ahead. Other recent statistics have also proven that the US economy is more resilient than most observers expected. This has put pressure on bond prices. Furthermore, technical factors for the bond price meltdown have taken centre stage as leading governments throw money at macro-economic problems, compounded by a growing number of armed conflicts, even wars, in strategic parts of the world. This is once again most evident in the USA, where the government’s solution to most problems lies in borrowing, spending, and taxing. In so doing, this government is ignoring the old adage whereby today’s national debts will be tomorrow’s taxes. The FT estimates that $1.8 trillion of new US treasury issues will have flooded the market once this year has run its course.

This irresponsible spending programme has caused the budget deficit to explode towards eight per cent of GDP, as well as raising the borrowing requirements because of the much higher debt-to-GDP ratios that have developed for various reasons in the US. The result is a plethora of new bond issues at a time when the ultimate marginal buyer of last resort, the Federal Reserve, has not only withdrawn as a major player but has embarked upon a shrinkage of its balance sheet through quantitative tightening. This means that instead of being a forced buyer, as in days of yore, the Fed has now become a forced seller at the same time as the US government has become a forced issuer. This wave of Fed selling amounts to $80 billion per month. At the same time, it has been reported that US debt servicing costs now exceed defence spending, even though that country has substantially higher defence spending, relative to GDP, than other leading countries.

In previous months it has been estimated that the traditional marginal buyers such as US pension funds or insurance companies and other institutions will take up the baton as bond yields rise and place a limit on their relentless upward drive. Traditionally, US banks have been regular buyers of US bonds. Their actions have proven to be timid this year, not only because of strict capital rules but also influenced by the demise of Silicon Valley Bank earlier this year when mark-to-market losses in US treasuries caused a run on this and other banks. It is estimated today that the bond paper losses sitting on US institutional balance sheets that have arisen from the collapse in bond prices add up to a staggering $15 trillion. On top of that, foreign buyers of Treasury bonds, and in particular the Chinese and Japanese investors, have reduced their purchases. This has been done for differing reasons, not least the Chinese (probably fruitless) drive to de-dollarise world trade and replace the US dollar with the Renminbi; or the yields on Japanese government bonds finally rising, making it more attractive for Mrs. Watanabe to repatriate her capital from US markets. The simplest reason for falling bond prices is thus the imbalance between buyers and sellers.

This newsletter concentrates mainly on the situation in the USA. This is because US dollar financial markets represent the leading world benchmarks and today, they are strained. But the picture in the eurozone reaches similar conclusions and will be analysed further in subsequent reports.

The horrendous new wars in the Middle East have conjured up memories of the 1973 Yom Kippur wars that resulted in a quadrupling of the oil price by the OPEC cartel and an explosion of inflation and interest rates. It would seem, however, that these comparisons are misguided. At the time, the world economy was far from open and free. Oil prices were set by OPEC, not by free market forces. No major international trade agreements were in place, as capital and foreign exchange controls, as well as many other tariff and non-tariff barriers, were the norm before the picture changed around the world and trade eased gradually and substantially. And many other elements of everyday life are now distant bad memories that are gone forever, such as an absence of the internet, no photocopying machines or printers, or no mobile phones, to name the most obvious. There are many more. Now, this has been replaced by the knowledge-based economy that we have grown accustomed to. There is no comparison to those difficult days that marked the first and then the second oil shocks.

Although today’s death and destruction in Israel and Gaza have taken an intolerable humanitarian toll, the knee-jerk reactions of the all-important oil prices – and by extension expectations of future inflation – have been subdued pending the absence of unpredictable players such as Iran.

It is easy to conclude that the path of least resistance for bond and share prices is downwards, with corresponding rises in bond yields. Nonetheless, Quality Growth investors cannot afford the luxury of pessimism as they dig deeper into their underlying businesses to get to the bottom of how, if at all, rising bond yields affect their portfolio of the best companies in world and what the right path is to take in times of such volatility.

Our thoughts on the first of these two questions have been well-documented over time, not least in the newsletter of Corentin Massin this month (The Debt Lag). We shall not deprive our readers of the chance to read that piece by going into detail here, save for stating the obvious problem that large debt payments increase the risk of bankruptcy and at best make the management think twice about important opportunity costs.

The second question finds its answer in the long-term nature of our investment philosophy. In times of great volatility, there is a strong temptation to question long-standing beliefs and to stray from the investment philosophy. This is a grave mistake. Style drift not only undermines past performance but also destroys credibility in the eyes of underlying investors, who can no longer rely on predictable behaviour.

The cure for this malady is to ignore market noise and to focus on the numbers that matter but simplicity masks the challenge – many investors have strategies and philosophies that are tested in difficult markets and in fact many of those same investors stretch and bend their strategies and philosophies in an effort to stem underperformance. There are, however, some ingredients that make it easier. The first is an acceptance that trying to time the market is a fool’s errand that has a greater likelihood of getting the investor into trouble than out of it. The second is the high conviction in home-grown research that allows the investor to take unpopular decisions with confidence. The final is an investment philosophy and process that are specifically designed to protect the investor from style drift by restricting their opportunity set to the very best companies, which by definition are the same companies in both a bull and a bear market. The only difference is that in the latter, they can be found at a better price.

P. Seilern and MJ. Faherty

October 30^th, 2023

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