Earlier this morning we presented the first quarter investor letter from Broyhill Asset Management's Affinity hedge fund where we highlighted their contrarian bet on long-term treasuries. In a time when seemingly everyone is betting on inflation, Broyhill has taken a converse stance and thinks caution is warranted. They anticipate an acceleration away from risk assets and into fixed income. They recently posted up the rationale behind this position on their blog View from the Blue Ridge and we wanted to highlight the key takeaways from their deflationary wager. Thus, we continue our impromptu inflation versus deflation debate as we earlier cataloged how hedge fund manager Kyle Bass sees inflation & currency devaluation in store around the globe.
Believe it or not, Broyhill had previously been short treasuries and covered in March. They've since gone long and see the 10 year treasury as an effective hedge against deflation. They have been buying here and will continue to do so on any weakness. Investors wishing to jump on this seemingly contrarian bet can buy exchange traded fund IEF for 10 year treasuries, or TLT for 30 year treasuries if you wanted a longer duration. This investment of course is in stark contrast to the myriad of other hedge funds that have been shorting long-term treasuries. Hedge fund Broyhill's rationale for owning bonds is refreshingly presented with various research found via the financial blogosphere. You can of course keep up with Broyhill's latest thoughts on their blog, View from the Blue Ridge.
Before getting into the ten reasons, we'll first start with their chart of 10 year treasury yields that has been in a decisive downtrend for the better part of two decades. Various crisis events over the past twenty years have caused momentary spikes in treasury yields, only to later resume the trend of decreasing yields.
And now, without further ado, here are Ten Reasons to Buy Bonds:
1. "Core inflation historically falls after the end of a recession. In the 11 recessions from 1950 through July 2009, the end of recession was followed by declining inflation, with CPI bottoming on average, about 29 months after the recession ended. Longer term inflation concerns are warranted, but there are more immediate threats in front of us."
2. "With core inflation declining and nominal economic growth rates weak in the aftermath of financial crisis, bond yields should trend lower in coming quarters. Investors looking to purchase long-term inflation hedges, should see more attractive entry points in the period ahead. Be patient."
3. "The average long term Treasury rate since 1870 is 4.3% and the average annual CPI is 2.1%. If inflation trends toward zero (before moving much higher later in the decade), then long term bond yields could naturally fall toward 2%."
4. "A near term deflationary environment bodes very well for long term bonds. Long term Treasury rates dropped from 3.6% in 1929 to 1.9% in 1941. Interest rates in Japan fell from 5.7% in 1989 to 1.1% in 2008 while the Nikkei dropped 77.2% over the entire period."
5. "The most common argument from Bond Bears is higher levels of debt must lead to higher yields. The reality is that the economic cycle still dominates intermediate swings in bond prices – a growing list of leading indicators are pointing to slowing economic growth ahead."
6. "The velocity of money is falling at the same time money growth has come to an abrupt stop. Monetary policy is effectively pushing on a string."
7. "Nearly 80% of money managers in Barron’s Big Money Poll say they are bearish on Treasuries. When everyone agrees that rates are headed higher, something else is bound to happen." As we here at Market Folly had posted up earlier, hedge funds had a record short position in 10 year treasuries, as illustrated below by Societe Generale:
8. "Similarly, retail investors are once again, near their highest allocation to equities at the market’s highs. I believe some call this Predictably Irrational. The last time bullish sentiment was this high was back in December 2007 when the S&P 500 was trading at 1500!" Bespoke Investment Group had in the past put out a graphic showcasing extreme levels of bullish sentiment found below:
Additionally, Pragmatic Capitalist charted out a survey of asset allocations that highlighted how everyone and their dog had moved out of cash and into stocks:
9. "Greek default and contagion risks across the Eurozone periphery. Cascading disruptions throughout the European banking system. This risk will not go away anytime soon. News will get worse before it gets better. Think back to how subprime was “contained” or how the Bear Stearns rescue marked the “panic lows” for the markets. Greece is a pebble in the Euro Pond. The ripples it causes will ultimately be very messy."
10. "Read number nine again."
Specifically regarding the recent implications of Greek default, we want to highlight that just this morning we posted how Kyle Bass' hedge fund Hayman Advisors is very concerned about currency devaluation and inflation around the globe. There's an interesting dynamic here because while Broyhill thinks the events in Greece will cause investors to 'flock to safety' in bonds, Hayman Advisors believes these sovereign defaults will only lead to inflation. The difference between these two stances is that Broyhill's position is based on a near-term reactionary move by investors while Hayman's thesis is centered on a theoretical long-term consequence.
An intriguing and well thought out set of reasons for a wager on bonds from Chris Pavese at Broyhill. They've definitely made a contrarian wager here and until yields on the 10 year treasury break out of that multi-decade downtrend, you can't really argue with their position in the near-term. Only time will tell whether we ultimately have inflation or deflation. But that certainly hasn't stopped hedge funds and investors from placing bets in the mean time.
Overall though, we've seen the vast majority of hedgies anticipating inflation. Howard Marks of Oaktree Capital laid out ways to play inflation. East Coast Asset Management came to the same conclusion of an inflationary stance in their deflation-reflation continuum research. And again as we noted this morning, Kyle Bass is now anticipating currency devaluation around the globe.
However, we do make note of a few select firms that are notably bullish on bonds and reside in the deflationista camp, including Hugh Hendry of the Eclectica Fund. Indeed, this is what makes markets great: a never-ending difference of opinion. Perhaps a compromise of views would be deflation in the short-term followed by longer-term inflation. We'll have to wait and see. For a primer on how to position portfolios for either outcome, head to our previous post on investment scenarios for inflation versus deflation.