While much is made of the 'wall of money' waiting to flood into US equities, it's instructive to look at actual fund flows. So far this year up until end November, emerging market equity funds have seen inflows worth $58.6 billion while US equity funds have suffered outflows of $80 billion, after more than $74 billion in redemptions in 2008. This reflects investor disillusionment after a dismal decade for US stocks but also the key demographic trend I explain frequently. Most US investors are simply too close to retirement to take another roll of the equity dice and are therefore shifting out of money market funds into corporate and government paper, with emerging market equities as dose of high Beta risk. Commodity funds have received an inflow of $14 billion YTD but these are still record-breaking numbers and gold's recent record breaking and headline grabbing streak will see those flows spike further on typical retail momentum investing.
The miserable yields in money market funds saw a switch to US bond funds which have taken over $80 billion so far this year. It's fascinating that we're seeing record flows into both commodities and fixed income, and it reflects unusually schizophrenic market views on the deflation versus inflation risks ahead. Alternatively, perhaps first we'll see more of the the former, and then the next phase of policy response will guarantee us the the latter. Standing back, virtually zero cash yields are forcing investors up the yield curve, with government bonds on 3-4% looking relatively attractive. It's just a personal version of the carry trade that allows banks to borrow cheaply and earn money by investing in longer-dated assets. However, history suggests caution when the yield curve is upward-sloping. In fact, the data for the US and Europe clearly indicates that buying long bonds when the curve is inverted (i.e. short rates exceed long) is the shrewd strategy according to a study by investment consultancy Smithers & Co. They point out that the historical difference between the returns on cash and conventional government bonds is very low, but cash is a lot less volatile and thus a better hedge against the equity market.
The period when yields have been most inverted in decades has seen subsequent 10-year real returns average 3.5%.Such buying opportunities in bonds included 1927 and 1928 (just before the crash) and 1989-1991, just before the disinflationary period of the 1990s driven by the Soviet collapse releasing cheap commodities and the rise of Asian offshore manufacturing. If you bought when the initial yield gap was highest, the subsequent 10-year real return averaged just 0.3%.The odds don't favour those piling into long Treasuries currently, which interestingly doesn't include foreign central banks, who have been steadily reducing duration. China is now only buying in the sub 3 year end of the market. In many ways, global bond yields are misleading right now, as they reflect the impact of trillions in central bank buying with QE funds, as well as aggressive attempts to re-liquefy bank balance sheets with negligible short rates.
Meanwhile, the chart above demonstrates the incredible narrowing of debt spreads this year. I was a big bull on corporate bonds going into 2009, describing them as a 'no brainer' trade, but I'm astonished by the scale of the rally given the still substantial default rate uncertainties. Clearly, the impact of Fed intervention has been enormous as can be seen by MBS spreads even lower than those seen in mid 2007 (the sector the Fed has been most active in), and overall yields have likely undershot fair value as a result of risk capital displacement from Fed purchases. That won't last much longer as those special liquidity programs are unwound. December 2008 was an historical buying opportunity in corporate and emerging market debt, but December 2009 is unlikely to prove so.
