The fear bubble

Investors keep putting money in negative-yield bonds and companies sit on cash. Why it’s killing the economy.
The fear bubble
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Earlier this month Louis Moore Bacon, the head of New York hedge fund Moore Capital Management, wrote to his investors offering them a $2-billion refund.

Bacon had made investors a fortune exploiting macroeconomic trends such as interest-rate and currency movements. But these days, he complained, the markets had become far too manipulated by fear for Moore Capital to promise the kind of double-digit returns its investors had come to expect.

Rather than looking for investments that might provide them a nice return, investors were paying big premiums to stash their cash in investments guaranteed to lose money in the long run on the belief that those investments might be the most likely to survive a global financial apocalypse. “Disaster economics, where assets are valued based on their ability to withstand a lurking disaster as opposed to what they may yield or earn, is now the prism through which investors are pricing markets,” Bacon wrote to clients. In this environment, his fund simply couldn’t make money.

Bacon is not the first multi-billion-dollar hedge fund manager to return money to clients or complain that the aftermath of the 2008 financial crisis has created a new era in investing where the old rules no longer apply. A growing chorus of doom-and-gloom types believe the financial markets that have served generations of investors so well for the past 100 or so years may finally be irreparably broken.

“The cult of equity is dying,” declared Bill Gross, the head of Pacific Investment Management Co., which runs the world’s largest mutual fund, in his August investment outlook. “Like a once bright green aspen turning to subtle shades of yellow then red in the Colorado fall, investors’ impressions of ‘stocks for the long run’ or any run have mellowed as well.”

The 6.6 per cent annual returns stock market investors have enjoyed on average since 1912 were merely a “historical freak,” Gross wrote. Today’s investors face a new reality, he argued, where their money might never earn them enough to make them wealthy, or even fund a retirement.

Four years after a major banking crisis rocked global finance, the economy seems stuck in a permanent state of pessimism and panic. Investors have taken to stashing their cash in government and corporate bonds, sending their prices skyrocketing and causing some analysts to worry that speculative bubbles are forming in what have traditionally been considered low-risk investments. Even farmland in Iowa has become a safe haven for worried investors, who have sent prices shooting up 24 per cent in the past year despite the worst drought in half a century. “It may sound odd, but we appear to be witnessing a speculative rush away from rational risks,” Paul Justice, a director of research at Morningstar, wrote in an April report. “We are in a fear bubble.”

Granted, investors have plenty to fear these days. The eurozone appears on the verge of collapse. China’s growth is slowing. The U.S. seems incapable of reining in its debts. There’s the LIBOR scandal that saw global banks manipulating a key interest rate, casting fresh doubts on the strength of the financial system. The markets themselves seem hopelessly manipulated: by central bankers who print money like it’s going out of style and then use it to buy back their own debt; by automated trading systems whose software glitches have created and destroyed millions in artificial wealth; by Facebook and its disastrous IPO.

But is the fear really justified? After all, it’s not the first time the death knell has been sounded on the stock market. In 1979, Businessweek famously declared “the death of equities,” shortly before the U.S. markets took off on their longest bull run in history. These days, even if the global economy is still weak, there are signs of a recovery. The S&P 500 hit a four-year high this month. The notion that the stock market might never again produce any value seems driven more by the psychological scars of the last four years than by the lessons of history. U.S. consumer sentiment, meanwhile, hit its highest level since May, while home sales rose 2.3 per cent in July. Corporate balance sheets are also rock solid, prompting Bank of Canada governor Mark Carney to chastise companies last week for sitting on “dead money.” “The level of caution [among corporate managers] could be viewed as excessive,” he said. “Their job is to put money to work and if they can’t think of what to do with it, they should give it back to their shareholders.”

Fear may not be the most obvious problem facing the economy, but it may now be the biggest threat.

While Carney has appealed for reason, his own actions haven’t exactly inspired confidence. The Bank of Canada has held interest rates at one per cent for the last two years—levels once thought reserved only for full-blown economic meltdowns—perpetuating the widespread belief that Canada’s relatively strong economy is perched on the edge of a precarious cliff.

Canada’s corporate executives, not surprisingly, have grown increasingly pessimistic this year, according to a survey released last week by the Canadian Institute of Chartered Accountants. Their pessimism comes even as a majority expect to improve their own balance sheets by boosting revenues, increasing profits and hiring. Still, many said they were waiting for the other shoe to drop—from a breakup of the eurozone to the results of the U.S. presidential election—before making major investments with their money.

“Certainly you’re driven to increase your return to shareholders, and growth is a way to do that,” says Doug Baker, a former Calgary-based oil and gas executive and a past chair of the Institute. “But when you’ve got a major uncertainty like [the global economy], you can also look back and say, ‘I might be making a company bet here. If I sit on the cash, the worst thing that will happen is I have a little lower returns in the future, but I’m still alive to fight another day.’ ”

And companies are holding a whole lot of cash: by the most recent count in Canada, more than $525 billion in reserves, or nearly enough to pay off the entire federal debt. That’s up more than 50 per cent since 2008.

While some companies sit on cash out of fear, others are finding they don’t have access to it for the same reason. With only 32 new stock market listings—just two on the TSX—in the first half of the year, 2012 is shaping up to be one of the worst years on record for Canadian public offerings, according to a survey by PricewaterhouseCoopers. Canadian IPOs have generated just $220 million in new equity this year, compared to $1.4 billion at the same time last year.

With confidence sinking, the market is no longer a very inviting place for many companies and their investors. So where is all the money going? Since 2007, nearly US$350 billion has left the stock market and nearly US$1 trillion has been stashed in bonds, according to the Investment Company Institute. Yields—the interest paid on the bonds—are at lows not seen since the 1940s. Germany, Denmark, Switzerland, Austria and Belgium have seen negative yields this year as European investors ran from sovereign debt crises in southern Europe.

Negative yields are exceedingly rare—with good reason. They essentially mean investors are paying for the privilege of lending money to governments. But they are becoming more common as investors risk everything to pay for the safety of the governments least likely to default on their debts.

Yields on 10-year U.S. treasuries have fallen 50 per cent since January 2011, even as the country faces a $1.3-trillion budget deficit and the uncertainty of a looming presidential election. Five-year treasuries are yielding less than one per cent, hardly enough to even cover inflation.

Interest payments that can’t even keep pace with inflation spell bad news for baby boomers, who are looking to preserve their savings for retirement and are also invested in pension funds, which are required to hold certain levels of so-called risk-free assets like government bonds.

Nearly 20 per cent of investors who bought the $5.7 billion in U.S. debt issued since 2007 have been households, a study by Capital Economics found. In the first quarter of the year, households invested more in treasuries than did the Federal Reserve and overseas investors combined. Nor have Canadian families avoided piling on U.S. debt, increasing their U.S. treasury holdings by about 40 per cent between June 2011 and June 2012, to US$62.8 billion.

The flood of money into government bonds is a sign of complete loss of faith in the stock market, says Marilyn Cohen, a bond expert and founder of Los Angeles-based Envision Capital Management Inc. “Baby boomers are just at the end of their ropes as far as being lied to regarding the stock market,” she says. “It’s a scream of ‘I can’t take it anymore.’ That’s been a big catalyst in siphoning money out of stock funds and into bond funds. Nobody really believes in the stock market rally.”

But just as the U.S. real estate bubble was predicated on a belief that house prices only go up, bond investors are fooling themselves if they believe that bond prices—in the midst of a 20-year bull run—can never fall. Interest rates, some warn, have fallen so low that they will eventually have to go up, causing bond prices to crash.

So much money has piled into the bond market that Jan Dehn, a strategist with London-based Ashmore Investment Management, warned that if interest rates return to their historic averages, bondholders could stand to lose more than 30 per cent of their investment. Such losses, he wrote, could be “potentially many times costlier than a Greek default.” Buying U.S. treasuries is like “walking in front of a steamroller to pick up a dime,” Leon Cooperman, CEO of Omega Advisors, told an investors’ conference earlier this month.

Investors need only look as far back as 1994, when bond prices collapsed after a surprise interest rate hike from the U.S. Federal Reserve, wiping out more than $1 trillion in investment in what Fortune magazine dubbed “The Great Bond Market Massacre.” “There was blood everywhere,” recalls Cohen of the crash. Back then, 30-year bond yields fell as low as six per cent before they started to rise, causing prices to fall. Today, the same bonds yield less than three per cent. (A similar surprise rate hike in today’s climate seems highly unlikely, though not impossible.)

Some major firms are already starting to reconsider their bond investments over fears of a bubble. Man Group, the world’s second-largest hedge fund, reported it was changing its computer algorithm for its automated trading systems to limit its exposure to the bond markets over fears of a bubble.

Norway’s state-owned $600-billion oil fund, considered one of the world’s largest sovereign wealth funds, confirmed that it was also reassessing the bond market. “It is extraordinary,” the CEO of the firm that oversees the fund, Yngve Slyngstad, told the Financial Times. “We have to ask the obvious question of why investors are paying for lending money and are not just keeping it in cash.”

As the so-called bond bubble grows, it risks setting off a domino effect of other potentially troublesome and equally counter-productive trends. Low yields on government bonds have pushed investors into buying corporate debt, driving interest rates on corporate bonds to historic lows. That is sparking a wave of new issuances as companies jump on the prospect of being able to access cheap debt even as they stockpile huge sums of existing cash.

Among the companies who have sold bonds in recent months are bailed-out insurance company AIG, who sold $250-million worth of three-year bonds, and Canadian oil firm TransCanada, who sold $500-million worth of 10-year bonds last month.

Ratings agency Standard & Poor’s warned this spring that the global “wall” of corporate debt set to mature between 2012 and 2016 had reached $30 trillion. In a sign that the corporate bond rally may be getting out of hand, last month British bond fund pioneer M&G reportedly turned down $1.5 billion worth of business in institutional corporate bond funds over concerns from the British regulator that if investors ever needed to sell en masse there may be no buyers left, triggering a meltdown in the market.

The glut of money piling into bonds and pushing interest rates down has also done nothing to encourage governments to rein in spending, since they can simply issue more cheap debt. Global public debt, according to the Economist’s debt clock, topped $48 trillion and counting this year, up from $29 trillion in 2007.

In Canada, the falling yields on government debt have likely saved the federal and provincial governments a combined $80 billion in interest payments since 2007, including $25 billion this year alone, wrote Warren Lovely and Avery Shenfeld of CIBC World Markets in a July 30 report. Yet federal and provincial debt has continued to climb since the financial crisis, even though, combined, Ottawa and the provinces spent $3 billion less than they expected on interest payments last year.

Carleton University economist Nick Rowe blames central banks for creating an atmosphere of uncertainty that has made it difficult for investors to know just how bad things might get before they start getting better. Investors who lock their money away in 10-year government bonds in the belief that the global economy is on the verge of a precipice can actually push the economy further into recession. Uncertainty is creating fear, and fear becomes a self-fulfilling prophecy. Rather than spurring economic growth, low interest rates have the added effect of forcing households to set aside even more cash for their retirement when they’re earning nothing on their investments.

“This is the proverbial paradox of thrift,” HSBC’s global head of asset allocation Fredrik Nerbrand recently wrote in a report to clients. “And it has an impact on demand.” Rowe argues that central bankers need to give investors a clearer idea of just how much money they’re willing to print to dig their economies out of recession, lifting the cloud of uncertainty. “As soon as that started to happen, the economy would recover. Investment would take off. Interest rates would go up,” he says. “It would be a self-justifying escape.”

There are few signs, however, that the fear is subsiding. Stock market analysts have already warned about a “triple top” forming in the stock market, a series of three rallies followed by big declines that signals the start of a major sell-off. But that may be fear talking again. Overlooked is that these kinds of ups and downs are hardly new. Stock markets saw four busts between 1968 and 1978. Far from watching the death of equities, Ben Inker of investment firm GMO sees a stock market returning to normal after a decade of unsustainable bubbles in everything from tech stocks to subprime mortgages. “The last 12 years have been part of an essential healing process for U.S. equities, and have brought valuations down from 44 times normal earnings to 21 times,” he wrote in a paper earlier this month. “As we analyze equity returns, this means the healing process is not yet done, and the U.S. equity market is likely to continue disappointing investors for a few years longer.”

In other words, we need to take the long view. Yet investors are still likely to keep pouring their money into safe havens such as bonds. But bond expert Cohen warns the fear bubble building today will eventually burst.

“I’ve lived through a lot of bear markets on bonds and it’s painful and terrifying, and people who thought if they were in bonds they couldn’t lose any money had their Jesus moment that they were wrong,” she says. “When it comes unwound—and it will come unwound—it’s going to be one massive, ugly situation.”

So perhaps, after all, there is good reason for fear—it’s just misplaced.