The fixed interest market as a whole has been very difficult to interpret for investors for a number of years, with sentiment often driving markets ahead of fundamentals, and in the background the continued support of loose monetary policy by central banks around the world.
Following the financial crisis, central banks across the world, and especially in the States and UK, believed that a focus on asset values would result in higher growth and the avoidance of deflation. There was a belief that boosting asset prices would encourage consumption, partly due to historical evidence showing that periods of high economic growth had always coincided with high asset prices.
There was also a belief that this wealth effect would filter down through the general economy and encourage investment as the cost of capital for companies was lowered. Policies progressed from low interest rates to zero rates and then the large scale purchase of market securities, which in Japan has even included equities. Some companies seem to be on the route to nationalisation with the Bank of Japan now owning 15 per cent of their equity.
There has also been a belief that both the European Central Bank (ECB) and Peoples Bank of China can continue to loosen policy and aid global liquidity, which in turn would continue to support or boost asset prices. Recent comments by the ECB about not increasing the level of QE came as an initial shock to markets. There may now be a return to the sentiment that prevailed in the early months of this year – that the omnipotence of Central Banks has come to an end and their ability to deliver to investors high returns combined with low volatility is over.
Investors looked to exploit central bank policy by not only purchasing what central banks bought but also trying to anticipate where they might go next. This partly explains the market reaction in the immediate post EU vote period. Central bank activity also repressed volatility in financial markets, which resulted in the fulfilment of the initial desire of central banks to encourage investors to take more risk. There is an argument that this has now gone too far and investors who should – by the nature of their financial position – be low risk, are encouraged into assets with significant potential downside in capital values.
In recent years investors have been used to seeing stocks and risk-free government bonds move in tandem, which in itself detracted from the benefits of risk reducing diversification. As we go into the fourth quarter of the year, central bank policy divergence is likely once again to come to the fore, as the US alone seems set on a path of monetary tightening in 2016. Whether any other major central banks will follow suit in 2017 remains to be seen. US officials are also undoubtedly concerned about their lack of ammunition in any further economic downturn and while not ruling out a possibility of further unconventional measures in this eventuality, there is probably a desire to try and normalise rates to some degree when the opportunity arises.
There may also be a realisation that zero rate policies do not work for large sections of commerce or society, with both banking and insurance company business models struggling in the current environment of ultra-low rates and flat yield curves. Consumers may also be forced to actually save more as the capital needed to generate returns from low risk investments has increased substantially.
Even though a slight shift in policy mix is now apparent and will be reinforced over time, this does not mean the era of cheap money is over. Central Banks everywhere will remain accommodative by historical standards, even in the States. While US interest rates are likely to rise once this year, the medium forecast of the Federal Reserve for 2017 interest rate increases has been pared back to two.
There are powerful secular forces such as the demographics of an ageing population in the developed world, together with high debt levels that will restrain economic growth. In a lower growth environment the extent of the rise in longer-term yields will be limited. Many central banks are committed to bond buying programmes over the next couple of years at least, although they may look to concentrate their purchases on the shorter end of the curve to help their banking systems. Nevertheless the negative price impact for a 1 per cent rise in yields on a low coupon 10-year bond is not insignificant and with bond yields so low there is little in the way of carry to offset any negative move in capital values.
UK investors need to consider how the changing global backdrop to monetary and fiscal policy should affect their investment strategy. There is no doubt that post Brexit, the threat to sterling has been magnified and this has already manifested itself in a slide in its value and more recently the flash crash which took levels down to a dollar exchange rate of $1.18. This suggests that holding global bonds ahead of sterling-based bonds as part of a portfolio makes sense, provided they are unhedged, to protect against further sterling weakness. In addition the strength of emerging market debt has been a feature in 2016 and as long as we continue to see dollar and commodity price stability then this area of fixed interest debt looks to be a reasonable choice to diversify away from UK government and corporate debt.
For investors, an overreliance on UK debt both government and corporate does not make sense in a post Brexit environment. The global backdrop is changing with yields potentially rising across the globe, albeit not at a particularly fast pace, thus a strategy which encompasses a wider perspective in our view delivers a better risk adjusted portfolio.
Our fund choices in this area would include:
- Legg Mason Brandywine Global Fixed Interest. Driven by macro views that determine the themes, this fund invests in sovereign investment grade securities and looks to generate alpha from currency and duration positioning
- M&G Global Macro. An unconstrained, macro-driven fund, it has a large credit team which provides strong technical analysis and is balance sheet based.
- M&G Emerging Market Bond. This fund has a flexible mandate operating without index constraints which allows the exploitation of a wide range of markets across the region.
- Invesco Perpetual Global Bond. Using a macro process it mainly invests in government and investment grade holdings.
Ken Rayner, director at RSMR