A Bad Year for Common Sense
by Gerald Hwang, CFA, Portfolio Manager, Matthews International Capital Management, LLC
The phrase “common sense” can be a paradoxical concept in investment conversations. Seemingly imbued with a perverse, reverse meritocracy, the catchphrase appeals to investors as an intellectual leveler. It suggests, “Let us think things through logically.” Not only does this sound good, but what could be more egalitarian and humble? But when investment managers consider something to be “common sense,” be wary.
Let's take a look at how common sense failed bond investors this year.
Risky or Risk-free: Which Is It?
From the start of the year until the end of November, long-dated U.S. Treasuries generated 26% in returns. Few market participants were predicting such a rally. Sober analysts with common sense made note of the low yields early in the year and an economy that was two years past the peak of the financial crisis. The probability of further rate declines appeared low with the Federal Reserve at ZIRP (zero interest rate policy). Some bond investors even shorted Treasuries outright, assuming that some combination of factors (such as better economic growth prospects or a pickup in inflation) might drive rates higher.
Regarding any potential flight to Treasuries caused by stress in Europe, common sense dictated that this was already priced into the market: yields were already extremely low. But they headed lower. This is bad news indeed for those holding Treasury shorts and who are benchmarked versus indices with a heavy government component.
Euro Stability Amid Political Chaos
The euro is up about 0.5% versus the U.S. dollar from the start of the year through November 30. The European Monetary Union itself is a magnified example of the "tragedy of the commons." Just as individual sheepherders acting rationally will plunder a commonly held pasture, so too have individual countries acting rationally plundered the common currency. The relatively tight trading range of euro versus U.S. dollar, and the relatively flat year-over-year performance of the euro has confounded many investor expectations. This has been particularly baffling given the severity of the underlying crisis and the market's consensus view of its intractability.
Japanese Government Bond Outperformance
Investors have a number of good reasons to dislike Japanese Government Bonds (JGBs). U.S. holders of JGBs enjoyed a 6% year-to-date total return—which is surprising given the low yields across the entire Japanese curve. At the start of the year, the 10-year JGB yielded 1% (and you thought the U.S. 10-year bond was low at 2%!). Two surprises are attached to JGB outperformance. First, Japanese yields declined slightly from those already-low levels, creating a capital gain. Second, a 4.5% appreciation in the yen versus the U.S. dollar augmented JGB returns to U.S. dollar-based investors. (And the yen appreciated 3.9% versus the euro.)
It is unlikely that many bond investors outside Japan overweighted JGBs in anticipation that the minimal carry would be so strongly augmented by positive yen returns. Japan has the developed world's highest debt/GDP ratio. Recovery efforts from the earthquake and nuclear disaster would suggest that this ratio would rise. Japanese demographics suggest that the growing ranks of the elderly will cease being net providers of capital to the Japanese government. At least this year, none of these factors mattered.
Given the extraordinary macroeconomic conditions in which we find ourselves, perhaps some of these performances are not out of keeping with the environment. High levels of unemployment in the West have been paired with tight fiscal policy and less-than-accommodative monetary policy, which itself seems absurd. In Asia, India and China have been stepping on the brakes for most of the year.
Perhaps next year, counter-intuitive investment theses will continue to prevail over false “common sense.”
Gerald Hwang, CFA
Portfolio Manager
Matthews International Capital Management, LLC
The subject matter contained herein has been derived from several sources believed to be reliable and accurate at the time of compilation. Matthews does not accept any liability for losses either direct or consequential caused by the use of this information. Investing in small- and mid-size companies is more risky than investing in large companies as they may be more volatile and less liquid than large companies.
