Tuesday, June 28, 2011

Bonds x Stocks starting in 1982. And the future.

A very interesting chart from Research Puzzle (ht Distressed Debt Investing): performance of the S&P 500, the Barcap Aggregate, 30yr US Treasuries (I would say the bond is rolled every once in a while to keep the duration stable) and Gold since 1982.

The bottom panel of the chart brings the yield on the 30-year US Treasury.

What will happen in the next 30 years?
Living in Brazil, with nominal sovereign yields in local currency at around 12.42% for Jan2021 (10-years) and inflation-linked yields @ 5.92% (Aug2050, 40 years) I really get to think about opportunity costs adjusted for volatility. Current inflation is running above 6% YoY. The inflation-target is 4.50% +/- 2% (so top of the band is 6.50%, we're there right now).

I quit having brazilian equities in July of last year and now with the SELIC rate at 12.25% (eff @ 12.17%) I really do not know when I will go back into equities. The forward P/E multiple for the Ibovespa is 9.88 with gives an yield of around 10%.

That means the stock index earns less than the nominal risk-free yield but with a lot more volatility and possible tail-risk/downside risk (global risk factors, mostly).

Do I believe we're in a global environment of multiple expansion? No.
- Current inflation in Brazil is hovering the top of the central bank's band.
- The quality of the inflation is horrible. It is a lot of service inflation that has a very strong inertia. It is not just commodities, raw food prices or fuel.
- Inflation expectations are very high too, especially compared to previous year's behavior when expectations were well anchored.
- The global environment is hostile. I don't buy the Chinese immortality case and I don't like the European Debt problems
- I do not like the US story either.


Now some analysis of the future:

Brazil did grow 7.5% in 2010, but that was on the back of low growth in 2009, with massive fiscal stimulus in Brazil and worldwide, from a lower base, with low inflation and a come back in agricultural commodity prices.
Foreign flows have already made the brazilian stocks not so cheap (P/E > 9 x high bond yields). It has been a great 10-year run with inflation lower and lower and booming global growth on the back of unprecedented credit growth everywhere.

So... if you look around the world it seems like a no-brainer. "Let's buy these bonds and head to the beach". Brazil has the highest real-yields in the world, by far.


In 2008, during the financial crisis, the yields on long-term (12-year fixed rate and 35-year inflation-linked) brazilian sovereign bonds in BRL spiked higher as foreigners fled the market. And I mean HIGHER. There was a rush to the exit-door of Braziland and these yields widened like 500bps. What a hit to bond holders. Then.. they collapsed as liquidity issues eased and the economic activity back-drop looked terrible.

... so that's (1) : Mark-to-Market

And now (2): Will inflation be as mild as it was in the US from 1982 until now?
A lot of people talk about hyperinflation. I am more of a deflationist type. Believing that DM-deleveraging will hurt growth and depress prices globally. But will commodities remain stable? Will food prices spike even higher? It has been a nice run already for corn, soybeans, wheat and others since the early 2000's.

What do you think?

Adding (1) and (2)... will we see another crisis that will make bond-yields sky-rocket (probably if the BRL gets crushed as it did, from 1.55/USD to 2.60/USD)? That would be the "best of two-worlds". But if the global backdrop looks worse than now I believe these yields will drop further and this time they won't skyrocket again.

*Disclaimer: charts and data are presented as I receive/see them. Sources are usually not checked for validation and my own calculations are of 'back of the envelope'-type. I am aware that some math that I do myself might be wrong and/or misleading to some extent. In financial markets the rate of change of economic data is often more important than the actual level and the perception of 'what is priced in' is more important than 'what is actually going to happen'. This is actually the way people pick entry and exit points. So... yes, sometimes you might say 'This guy is an idiot, this is way wrong!' with a high conviction, being right. Not to worry. Markets are made of expectations and the clash of conviction between its participants. Portfolio managers know that being an idiot is sometimes profitable and being smart is often a bad choice. It is all reality, sometimes good, sometimes bad. By the way: corrections to my analysis and intelligent debate is welcome. theintriguedtrader AT gmail do com

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