Why a top quant wants to be wrong about markets

Former Pimco quant Rebonato sees weak returns, inflation and sovereign debt troubles ahead

Riccardo Rebonato
Riccardo Rebonato

Riccardo Rebonato has spent a career trying to make sense of markets. Today, he’s finding they make little sense at all.

“It completely baffles me how we can have equity prices that are similar to the prices in December, when the word Covid was unknown,” says Rebonato, a finance professor at Edhec and former chief quant at Pimco.

“Everything points to massively lower prices,” he says.

Current stock market valuations fly in the face of asset-pricing theory, in which Rebonato is a leading expert. Given the uncertainty around future cashflows, investors should be demanding greater compensation for taking equity risk, he says. 

Bond prices defy logic too. Most sovereign yields up to 10 years plunged below 1% after central banks cut rates and committed hundreds of billions of dollars to buy assets in March. But governments are loading up on debt at a time when tax receipts to finance coupons are shrinking.

Asset prices “across the board” have stopped making sense, Rebonato says.

In another example of weirdness, 10-year inflation-linked bonds have a negative yield in the US, UK and Germany. “According to asset-pricing theory, that would imply investors expect real growth to be negative for a decade,” he says. “I don’t think that’s believable – or I hope not.”

Rebonato struggles to put a finger on just how frothy equity markets have gotten. Futures cashflows are “particularly difficult” to forecast because they depend so much on how fast a vaccine for Covid-19 can be developed.

In fixed income, paltry to negative real yields have forced investors to seek returns elsewhere. This is not a new phenomenon. Each round of quantitative easing squashed bond yields to new lows without any sign of a reversal when conditions improved. Central banks have engineered a set of “controlled asset bubbles”, he says, leaving investors with fewer and fewer good choices.

Where does this lead? “The prospects are really poor. Now is a bad time to be an investor,” says Rebonato.

The best option “as far as possible, is to stay on the sidelines”.  Beyond that, all he can suggest is reducing duration “in generalised form”, by which he means “cutting exposure in almost all markets”. He admits this is a “vacuous” proposal for most investors who have no choice but to put money to work.

Investors that hang on face a bumpy ride. Central banks that are sweeping up overpriced assets today will face balance sheet losses tomorrow, Rebonato fears. Those losses could spawn inflation and possibly trigger a new sovereign debt crisis.

The cleanest dirty shirt

Rebonato’s opinions carry weight. He led market risk and quantitative research at Royal Bank of Scotland before spending five years as global head of rates and FX analytics at bond giant Pimco. These days, he works on bond portfolio management and fixed income derivatives pricing as a professor at Edhec Risk Institute and Business School.

He has published widely, including a paper this year proposing a new model for predicting future US bond yields and risk premia in an age of central bank domination. Instead of relying on historical yield curves, the model uses data from the US Federal Reserve’s forward-looking predictions of future rates – its so-called blue dots.

Rebonato’s current outlook is bleak. He worries that central banks will incur losses on the bonds they are now scooping up. “The balance sheets of central banks are full of assets bought at prices that are unlikely to reflect future cashflows. Would future central bank losses matter?” he asks.

He thinks they might. Academic studies show a link between losses and inflation, as central banks print money to recapitalise. “We shouldn’t take it for granted that inflation is dead,” Rebonato says. Academics still are unsure why inflation has been so low in recent years. In the 1970s, prices rose “quite suddenly”, he points out, with inflation in the US tripling from 3.2% to 11% in as many years.

Rising inflation would mean higher interest rates. That would make it costlier for governments to service their vast debt piles. 

Modern monetary theory – so in vogue with populist politicians – says governments can keep printing new money as long as inflation is under control. The theory may work in countries that control the money-printing presses, but not for those in the Eurozone.

Weaker members of the monetary union could see confidence in their bonds collapse quickly. Greece 10-year yields were trading at around 50 basis points over Bunds at the start of 2007, Rebonato points out. By 2009, the spread was over 200 basis points. In 2010 it was about 900.

Whatever-it-takes has been a masterful confidence trick. The question is whether the markets will at some point call the bluff
Riccardo Rebonato

He declines to name specific countries, but Italy is widely seen as an obvious candidate for trouble. Its growth has been half the eurozone average since the global financial crisis. Italy is also the most heavily indebted member of the EU. Italian government bond spreads over bunds widened to more than 300 basis points in recent months but have tightened to around half that after EU leaders agreed a €390 billion ($452 billion) recovery fund to support members hit worst by Covid-19.

Mario Draghi quashed the last sovereign debt crisis with his promise to “do whatever it takes” to save the euro. Perhaps central banks can navigate another one with a similar playbook. Such action, though, may not work twice. “Whatever-it-takes has been a masterful confidence trick,” Rebonato says. “The question is whether the markets will at some point call the bluff. When there is a pressure point, the pressure doesn’t go away unless it’s resolved.”

Could a return to economic growth get investors out of the jam? It’s possible, but unlikely, Rebonato thinks.

Dividends and coupons ultimately track what the economy produces, minus the cost of labour and tax. And today’s asset prices are counting on levels of production that defy belief. “Asset prices can only be justified if everything pans out in the rosiest scenario,” he says.

From 1850 to 1900, global growth stayed below 1%. Only after World War II did it rise to the 3%-or-so levels that are considered normal today. “In the history of mankind, there was a unique 30-year episode in the data,” says Rebonato.

For the same basic reason, Rebonato sees little reason to believe central banks will shrink their balance sheets in a controlled fashion over time. “Central banks have painted themselves into a corner” by acting as the “ultimate underwriters of equity markets”, he says, the Fed in particular. They are holding on for an economic boom before trying to wean the markets from support, he thinks. The boom probably won’t come.

Several times during the interview, Rebonato repeats that he’d like to be wrong. “Is the economy really going to produce so much? I hope so. I really hope so,” he says. Ultimately, though, he envisages poor returns continuing potentially for years. “These things can be sustained for long periods.”

In the meantime, there will be no easy course for investors. At Pimco, Rebonato recalls how Bill Gross likened the dilemma investors face to picking the winners in a cleanest dirty-shirt contest. That’s the task now. The trick, he says, will be to decide “which asset classes are less bubble-inflated”.

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