There’s a whiff of disinflation in the air in Canada and the U.S. – and, if you look to Greece, of deflation – which is making low-yielding government bonds look a lot more attractive.
This is not the robust revival that the U.S. Federal Reserve Board’s tapering agenda for its monetary stimulus program and the presumed return to normalized, mid-single-digit interest rates predicted. As a result, 10-year government bonds are paying positive real returns. And, in the middle of the yield curve, there’s a sweet spot that offers safe, positive returns for clients who hold government bonds to maturity.
Clients who want a shock absorber for their equities – or even a return with no surprises – have done the unexpected, loading up on government debt that, at best, will pay a couple of percentage points a year. Indeed, yields, which move opposite to bond prices, fell in the third week of January, suggesting that money is running for cover in government bonds as equities tumble.
The evidence for the surprising rush to buy government bonds is in the numbers. As of Dec. 1, 2013, the latest date for which data were available, Canada’s consumer price index (CPI) was up by an annualized rate of 0.9%. At the time of writing in late January, 10-year Government of Canada bonds paid 2.4% to maturity. That’s a locked-in real return of 1.5% – which is guaranteed if the bonds are held to maturity.
Regarding the U.S., with its CPI for the same period at 1.5% and its 10-year Treasury bond paying 2.72%, the real yield is 1.22%.
These real returns, which are close to the average of what bellwether U.S. and Canadian sovereigns have paid since the end of the Second World War, won’t elicit shouts of glee. But they could get better if investors flee from equities in a market correction, as happened in late January.
For your clients who have the appetite for a little more risk, provincial bonds, with a 70-basis-point (bps) boost over 10-year Canadas, and AA-rated 10-year corporates, with a 120-bps bonus over Canadas, make the case for buying real returns even stronger.
Disinflation already is underway in Europe. Germany’s inflation rate, at 1.3% a year, is the highest in the eurozone, while Ireland’s, Spain’s and Portugal’s CPIs are up by just 0.2%-0.3% on a year-over-year basis. And Italy’s annualized inflation rate is 0.7%. In this context, North America’s low inflation rates seem to offer an attractive basis for investing in government bonds.
The idea of deflation, the downward price trend after disinflation, is foreign to Canadian and American investors. There has been no sustained deflation in North America since the end of the Second World War. Yet, it’s being talked about by monetary authorities.
For example, Christine Lagarde, managing director of the International Monetary Fund, warned of the growing danger of deflation in a speech at the National Press Club in Washington, D.C., on Jan. 15: “With inflation running below many banks’ targets, we see rising risks of deflation, which could prove disastrous for the recovery.”
The outlook for Canada’s inflation rate is to the downside. Stock investors are discounting downside risk, notes Craig Wright, senior vice president and chief economist with Royal Bank of Canada in Toronto: “The CPI has 28 components, and 75% of those are below the CPI average. It’s true that government services prices are rising, but the CPI basket components subject to market forces are below the 2% mid-point of the Bank of Canada target inflation rate.”
In other words, the CPI is being pulled downward, component by component. For your clients, the choice is between last year’s momentum of soaring stock markets and taking shelter in bonds. Stocks were ascendant until the end of 2013 in spite the outlook, according to numerous forecasts, for what are likely to be disappointing reports in this year’s first-quarter earnings.
Equities investors willing to take more risk are paying more and getting less forward earnings. This can’t last. The alternative is to take a contrarian position in bonds, which adds the potential for disinflation in Canada and northern Europe or deflation in southern Europe. If nothing else, a drop in equities price levels sustained over a few quarters would push more investors to government bonds and, perhaps, top investment-grade corporate bonds.
The Bank of Canada’s response to potential deflation already can be seen in the dropping loonie. More exports, more jobs and higher prices for consumer goods should be bullish for the economy. Yet, the present trend is that CPI rates are so low that even a drop in consumer confidence or more bad winter weather delaying or cancelling consumer purchases could push down inflation into disinflation. Actual deflation would be a matter of going from inflation of just 0.9% to something mildly negative.
“Deflation fears have not gone away,” says Chris Kresic, senior partner and head of fixed-income with Jarislowsky Fraser Ltd. in Toronto. “That’s what is driving bond prices up. There’s persistent softness in inflation – that is, disinflation. We could get negative CPI numbers.”
“Global overcapacity is pulling down Canadian prices – and that translates as disinflation,” says James Hymas, president of Hymas Investment Management Inc., a specialty fixed-income investment firm in Toronto. “The prospects of sluggish consumer demand and inflation running below target levels translates as growing downside risks to inflation. That’s what makes government bonds and investment-grade corporate bonds attractive despite the outlook that, someday, interest rates will ascend to their historical norms.”IE
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