The worst place to invest, except for all the others

If Winston Churchill were alive (and managing money) today he might say “the United States is the worst place to invest, except for all the others.” The U.S. economy is experiencing a historically-low growth recovery, owing largely to a polarized and gridlocked government. Equities are at the expensive end of their historic range while the denominator in the value equation, corporate earnings, is deteriorating. Government bonds are trading at record-low yields, with riskier corporate and structured credits offering returns usually associated with safe-haven assets. However, all the adverse conditions making U.S. investors anxious are present to an even greater degree around the world. 

To read the entire Wall Street Weekly newsletter, subscribe for free. 

Just as the U.S. economy looked to be turning a corner in May, and speculation intensifying about a summer rate hike, markets were jolted out their sense of complacency by last Friday’s bombshell jobs report. The 36,000 non-farm jobs created were the fewest in more than six years. Given a week to further digest the news, global investors didn't return to a state of blissful zen, stampeding out of risk assets and back into safe havens.

On Thursday, an auction of 30-year U.S. treasury debt saw near-record demand from foreign buyers at the lowest interest rates in nearly 18 months. The 2.461% yield may seem paltry for a 30 year commitment, but in the land of the blind, the one-eyed man is king. German, Japanese and Swiss 30-year bonds are now trading at historically-low yields of 0.59%, 0.28% and 0.07%, respectively. For the latter two, 10-year yields are negative, while a third straight week of gains for German bunds saw the 10-year yield fall to 0.02%. 

Yields are also falling precipitously in the global corporate bond market, with Toyota this week selling $186 million worth of yen bonds at the record-low yield of 0.001%. Eurozone corporate bond yields also fell to lowest levels in more than a year as the European Central Bank (ECB) kicked off its controversial program of corporate-bond purchases. 

The attraction to cash-flow generative assets isn’t limited to treasuries. After a brief lull in demand from mid-February to early March, investors are now rushing back into municipal bonds. While so far this year $40 billion has been pulled from equity vehicles, investors have poured $22.5 billion into municipal bond funds, the asset class's best start to a year since 2009. The heavy municipal flows are occurring despite selective woes for the sector. The U.S. government is finalizing a debt restructuring plan for debt-strangled Puerto Rico and exasperated BlackRock is calling for Illinois to be banned from raising further money in the municipal market until it gets its act together. 

Mutual funds are also scrambling to buy corporate bonds, causing credit spreads to narrow again after a technically-driven widening in the first quarter. Money managers' allocations to corporate bonds reached a fresh all-time high last week of 36.3% of portfolios, according to Stone McCarthy.

As the Fed moved to start tightening monetary policy last year, pundits also warned about the risk of dislocations in value-oriented sectors of equity markets that had benefited disproportionately from the Fed’s zero interest rate policy (ZIRP). However, with rates hardly budging from lows, investors have continued to flock into safe-haven, dividend-yielding sectors. The 24% one-year return for utility stocks (XLU) nearly doublies returns of the second-place sector, consumer staples (XLP). 

Gold has also spiked to three-month highs, setting its sights on its most recent pivot top from late-April. 

Janus’ Bill Gross called the preponderance of negative interest rate bonds akin to a “supernova that will explode one day.” Carlyle Group’s Jason Thomas believes low and negative interest rates have actually had the perverse consequence of discouraging business investment because they more directly incentivize companies to buy back shares and raise dividends. 

While the global economy may not be as volatile as the financial markets it underpins, a new study released this week by Hyun Song Shin, head of research at the Bank for International Settlements, found that, "Financial markets, for their part, appear to be tethered more closely than ever to global events, and the real economy appears to dance to the tune of global financial developments, rather than the other way round.” 

With the global economy staring into the deflationary abyss and investors taking on significant duration risk in credit markets, every single data point has the potential to completely flip the narrative. A better-than-expected U.S. jobs report next month could put a July rate hike back on the table, but for now the Fed looks increasingly likely to hold off until at least late in the year. And maybe that’s not such a bad thing. The Fed has essentially “boxed itself in: by simply preparing to raise rates, the Fed triggers conditions that make it impossible to follow through.” 

Central bankers are always examining trade-offs between raising rates too early or missing the window altogether. Given the rising odds of a “Brexit,” which could further destabilize a fragile eurozone economy, it wouldn't be surprising for the Fed to happily miss its boat in 2016.