Economic Crisis

May you live in “interesting” times

“May you live in interesting times” is a phrase known as the “Chinese curse”. It sounds friendly enough but is reserved for the enemy. “Interesting” is this sense can be taken to mean unstable and unpredictable, and therefore likely to cause a lot of hardship. Growing social disorder, volatile financial markets, and the re-appearance of nationalist politics are all signs that we are now living through an “interesting” time.

In the past few weeks we’ve seen stocks (shares) and government bond markets both fall at the same time. This is highly unusual. When stocks sell off we’ve become accustomed to supposedly “safe” government bonds rising in price.

Developed market government bonds, such as US treasury bonds, have been in a bull market since 1981. Yields have fallen and so prices have risen for over three decades.

If we’ve reached the end point in that bull market then get ready for another round of financial and economic instability. Banks, pension funds, insurance companies and private investors are all heavily exposed to developed country bonds. Also many corporations have been borrowing heavily for years, because it’s cheap to do so. Rising yields will add to interest costs and hit profits.

Most homeowners are heavily exposed to bond yields as well, even if they don’t know it. That’s because mortgage rates are set by lending banks with reference to bond yields. If yields rise, mortgages will become more expensive.

Rising mortgage costs – driven by a bear market in bonds – could sharply bring down house prices. House prices are still in a bubble in most developed countries (except the USA, Japan and Germany).

At the same time consumption could be hit as homeowners are forced to spend more of their (already shrinking) incomes on mortgage interest – just to keep the roof over their heads. This would also hit corporate profits, as less money is available for non-essential purchases.

…iShares 20+ Year Treasury Bond ETF (NYSE:TLT), which holds government bonds with average maturity of 28 years, has lost 16.4% over that period.

In fact in the US – whose government bond market is still the most important interest rate benchmark in the world – bond yields have been rising since July last year. Yields on 30 year treasuries are up from 2.46% on 25 July 2012 to 3.53% on 1 July this year. The iShares 20+ Year Treasury Bond ETF (NYSE:TLT), which holds government bonds with average maturity of 28 years, has lost 16.4% over that period.

Are we already one year into the start of a long bear market in bonds, perhaps lasting for 30 years give or take a decade? In the past bonds have moved in long bull and bear markets, lasting decades on both the way up and the way down.

Given that US bond yields were at their lowest levels ever last July – going all the way back to 1790 – it’s highly likely that they will start marching upwards again at some point.

That said it’s possible they fall again in the short term, if we get a deflationary shock. We can’t know the future. We can only assess the likelihood of different outcomes. But this chart rams home the fact that bond yields have been, and are, at freak levels. And if you look at the gaps between the peaks and troughs you can see that the ups and downs in rate cycles typically last 20 to 40 years.

Long Term interest rates graph 1790 - 2010
See the trends in interest rates? The ups and downs in rate cycles typically last 20 to 40 years.

At the same time the recent protests and riots in Turkey and Brazil (Brasil) – and now in Egypt – are reminders of the social tensions bubbling along under the surface in much of the world. The reasons for the protests may be different in each country. In fact the protesters may have little in common with each other within each country except general discontent. The important point is that something is going on that is driving them onto the streets to defy their governments.

A whole generation has been thrown to the dogs by their “leaders” …It could – in fact it should – erupt into disorder at any time.

How long will it be until we see this kind of uprising across countries in Europe? Places such as Greece, Portugal, Spain, and Italy are particularly at risk. Youth unemployment is over 60% in some of those countries. A whole generation has been thrown to the dogs by their “leaders” and the faceless bureaucrats sitting behind comfortable desks in Brussels. It could – in fact it should – erupt into disorder at any time.

And how about the French? They like a good protest. It’s practically the national sport to go on strike. Well, so far they are protesting at the polls and not in the streets.

According to the Telegraph (a British newspaper), the Front National, a nationalistic far right party led by Marine Le Pen, received 46% of the votes in a by-election last week. They destroyed the socialists in what was supposed to be a safe socialist seat. In national polls they are running neck and neck with the two “mainstream” parties, the Gaullistes and Socialists.

Le Pen and her mob are preaching protectionism, want to leave the eurozone immediately, and could hold a referendum on leaving the European Union altogether if they get to power. France has always been at the centre of the European integration project. Could they be the ones to tear it down as well? Even if Le Pen can’t win power, there could be serious pressure placed on other parties to change their positions on Europe.

This is similar to the rise of the UK Independence Party (UKIP), whose main – possibly only – policy is to leave the EU. As voters steadily leave the Conservative party to join UKIP the Prime Minister has been forced to promise a referendum on EU membership (although handily after the next elections…). Nationalist parties are gaining prominence in several other European countries too.

Expect more market turmoil.  Expect more social unrest. Expect more political polarisation.

Here at OfWealth we think that investors need to understand the risks around them if they want their wealth to remain intact – let alone grow. It’s not a time to be scared. However, it is a time to be prepared. We certainly live in “interesting” times. But that doesn’t mean we have to be cursed.

Until next time OfWealthers,

Rob Marstrand

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Rob is the founder of OfWealth, a service that aims to explain to private investors, in simple terms, how to maximise their investment success in world markets. Before that he spent 15 years working for investment bank UBS, the world’s largest wealth manager and stock trader with headquarters in Switzerland. During that time he was based in London, Zurich and Hong Kong and worked in many countries, especially throughout Asia. After that he was Chief Investment Strategist for the Bonner & Partners Family Office for four years, a project set up by Agora founder Bill Bonner that focuses on successful inter-generational wealth transfer and long term investment. Rob has lived in Buenos Aires, Argentina for the past eight years, which is the perfect place to learn about financial crises.