How The GFC Morphed Into A GFZ

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By Rudi Filapek-Vandyck, Editor FNArena

We truly are living through "interesting times".

As calendar year 2012 matures according to its own script, yet another historic event has occurred and solidified. As investors and the media remain fully occupied by policy intentions in Europe, the US and China, this historic event has remained largely unnoticed, unreported and unanalysed.

But rest assured, we will hear a lot more about it in years to come with many academic studies and reflective analyses to be published in the decades ahead.

The event I am talking about is the switch between yields on government bonds and in equity markets. We have arrived at a point in modern history when dividend yields in the share market are higher than the yield available on 10-year government bonds in every major developed economy in the world, including in Australia.

Usually, when such an event happens, this is widely considered as a strong Buy signal for equities and we have certainly seen the bulls among share market experts make such calls over the year past. As this situation has persisted, however, those calls have been relegated to the sidelines, ignored by a global investment community that has to date shown no intention to return to the share market like it was 2004 all over again.

As a matter of fact, and as illustrated by the chart below (thanks to Citi analysts), the "usual" in the previous sentence refers to the period between the mid-1950s up until 2011 when the yield on government bonds indeed was higher, and often much higher, than what was available via the share market. But look further into history and it would appear that was more of an aberration instead of the norm. Before the 1950s, as also clearly shown in the chart below, the dividend yield on equities was higher than what was on offer via government debt. The last time this changed (prior to the 1950s) was in the late 1920s when equities rallied into an unprecedented bubble – at that time.

This easily explains why investors in equities, including the first professional funds managers, spent a lot more time and focus on company dividends. The father of modern day value investing, Benjamin Graham, acknowledged the value of dividends for long term investors and according to Charles Dow, founder of the world's most famous stock index, the ultimate value of an equity stake in a given company was derived from the company's future dividends.

Oh, how things have changed. From the moment consumer price inflation reared its ugly head in the sixties and seventies, bond yields soared and never looked like they were going to dip below dividend yields ever again. In the eighties, Paul Volker at the helm of the US Federal Reserve started the war on inflation and US government bond yields embarked on a long term decline. The bear market for bond yields fueled a once-in-a-lifetime boom for equities. Dividend yields have remained well below historical levels since.

It is thus rather ironic that even with average dividend yields for US share markets still well below historical averages (see also that same chart above), the US too has joined the likes of Europe, the UK and Japan with government bonds yielding even less than corporate dividend yields. As I stated at the beginning of this story: we truly are living through interesting times.

In case anyone is wondering: Japan was the first to see this historic switch between government bond yields and corporate dividends take place, in 1998, and neither has looked like making a switch back ever since. Most investors and superannuation funds in Japan avoid the share market like the plague and continue to seek out alternatives, including Japanese bonds even with corporate dividend yields at times reaching three times as high as bond yields (3% versus 1%). Amazing huh?

So… are we witnessing the "Japanization" of the modern, developed economies and financial markets?

That would be a big call to make. Let's all hope this is not the case, but we are witnessing some truly historic changes, so much should be clear by now.

Let's not beat around the bush: global bond yields are as low as they are because the mature economies are in deep trouble with growth sluggish, or absent, governments mired in debt, banks only solvent in theory and consumers understandably cautious about what tomorrow might bring. Under these circumstances, central bankers have effectively declared war on government bond yields as a last resort in keeping worst case scenarios away from the history books.

Within this context, economists at ANZ Bank launched a new acronym last week, the GFZ, otherwise known as the Growth Free Zone. The implication here is that the Global Financial Crisis, or GFC as we commonly know it, has accelerated the underlying problems in developed countries and has effectively pushed "growth" in any meaningful interpretation of the word out the proverbial window. Today, there is no "growth" in the UK, the European mainland, the US or in Japan. Despite a gazillion new electronic bank notes in each of these economic zones, there's no meaningful consumer price inflation either.

Under "normal" market circumstances, government bond yields are a reflection of official interest rates plus inflation plus an arbitrary risk premium or discount (usually set by "the market"). But with so much necessary de-leveraging still in the pipeline and with so much government debt still waiting to be addressed, can we expect this war on costs for government debt to end anytime soon?

I have an uncomfortable feeling the answer to this question is negative and we all should, as things stand now, consider the idea that we have just embarked on a journey of low yields all over again. After all, low yields were simply the norm prior to the 1950s so it could be argued we're closing off an era that was the historic exception in the first place (it started through out of control inflation).

Low yields are not by default a blessing for the world. Think about the trillions in superannuation schemes around the world, both sovereign as well as corporate, that rely heavily on yield from (supposedly) less risky government debt. Those superannuation obligations already are well behind previously defined targets and most definitely insufficient to meet future requirements. One more problem to add to the world's list.

Also, don't forget the impact on financial services providers, including life insurers whose business models will come under some serious stress in a sustainable low yielding environment.

Investors should also note the global reduction in low risk yield has not stopped Australian bank shares from de-rating. This might seem an odd conclusion given the banks have pretty much carried the Australian equity indices into positive territory so far this year, but stocks such as Commonwealth Bank ((CBA)) and Westpac ((WBC)) at current prices are still offering forward looking yields well in excess of 6%. Prior to 2011, such yield was usually only available in the sector after a sell-off, not at peak share price levels for the year.

In other words: despite a global search for sustainable yield, investors have still priced Australian bank shares in line with the sector's low growth outlook. Can this explain why equities are not by default the go-to arena during times of low growth, even if bond yields are not offering much as an alternative? (Note that, despite a world beating performance over the past three years, US equities have continued to suffer from net funds outflows and they still are today).

In Australia, the yield on 10-year government bonds sits around 3.25% after hitting an all-time record low of 2.80% in June. This suggests bond investors are signaling further deceleration in growth ahead, with the RBA's overnight cash rate likely to be cut at least one more time from today's 3.50% (and potentially as much as another 100bp in easing yet to follow).

Last week I met up with a few hedge fund operators and I can report they are studying scenarios whereby another round of QE by the Fed (most likely in accordance with major central banks elsewhere) might push the Australian dollar a lot higher from today's already elevated level.

This, so the theory goes, will cripple the Australian economy and force official interest rates down a lot further than is being contemplated by economists today. As Australia hasn't had a decent correction in its overpriced housing market yet, and with consumer debt levels near historic highs, the odds are then that rising unemployment will trigger a lot more bad news from the "Lucky Country". Ultimately, this will force a crash in the Australian dollar, but not before we have seen a lot of bad news first from the stock market, the economy, the RBA and from the Australian government.

Of course, at this stage this is nothing but a potential scenario, but it can serve as a reminder to investors they should be careful what they wish for. There is also still the possibility that all quantitative measures (effectively: money printing) by central bankers might one day once again unleash the ugly inflation monster. This could take us all the way back to the origins as to why bond yields surged well above corporate dividend yields some sixty years ago.

Prior to the unprecedented switch in the 1950s, bond yields were at all-time lows (for that time). Today, bond yields are even lower and, in my view, likely to remain lower for longer – at least for the foreseeable future.

(This story was originally written on Monday, 03 September 2012. It was published on that day in the form of an email to paying subscribers).

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