Since the financial crisis, central banks have been using loose monetary policy as the main tool to try to stimulate economic growth. However, recent moves by the European Central Bank, the Bank of Japan and others into the uncharted territory of negative interest rates, and the crowding out of investors from the bond markets, suggests that such an approach may be becoming counterproductive. Meanwhile, the US Federal Reserve yesterday decided to raise short-term interest rates, and it has forecast a faster pace of tightening over 2017. It is becoming increasingly clear that politicians are looking to try a different tack to drive economic growth: fiscal stimulus.
Tax cuts and the loosening up of the relentless increase in regulations could reignite some of the ‘animal spirits’ that have been lacking since the financial crisis. Economic growth could be supported and investment reignited with government investment in infrastructure. Government debt would increase, but this would be funded by the central banks, who print money to pay for the debt. Everybody wins.
Hold on though. If growth is picking up, won’t this ignite the latent inflationary trends that are just below the surface? Won’t we then get the bear market in bonds some have been anticipating? Possibly, but there is a limit (somewhat higher than current levels) at which the increased cost of very high debt may lead the authorities to try to lock bond yields.
However, in the meantime, the move towards fiscal stimulus is a significant change from the predominantly loose monetary/tight fiscal policy that has been in place since the global financial crisis, and as such we expect it to have a significant impact on bond yields. The short-term expectation that this will lead to higher inflation could cause yields to rise, but in some countries this will be offset by central-bank buying (aimed at keeping a lid on borrowing costs).
It is easy to see that fiscal schemes will be different for each country, and that central banks’ response will also be varied. As a result, the bond market reaction is also likely to be diverse.
How to cope with this significant change in prospects for bond markets
First of all, in our view, adjusting interest-rate exposure when yields are expected to rise, and diversifying into other countries which are not subject to falling bond markets, is going to be more important than ever. This is a cornerstone of our Global Dynamic Bond strategy.
In addition to this flexible approach, we employ an increasing number of techniques to generate returns when markets are changing rapidly. The following are seven ideas that we have been increasingly using in the strategy this year. By building a portfolio of different fixed-income return sources, we believe we can improve incremental return and reduce volatility.
- US Treasury Inflation-Protected Securities (TIPS)
When long-term inflation expectations drop, these securities start to offer value. This occurred at the beginning of 2016, when the falling oil price was expected to push headline inflation to very low levels. Once the oil price had stabilised, and working with our in-house commodity analysts, we concluded that it could continue in a well-defined, but low, range for some time. This would mean that the year-on-year inflation rate would start to rise once more (as the previous years’ falls dropped out of the calculation). Also, as it became clear to us at the beginning of 2016 that monetary policy was reaching its limit, we began to anticipate a shift towards fiscal stimulus, which could be interpreted by the market as more inflationary. As a result, we built up a position in TIPS.
- Buy bonds in countries where rates could be cut, and where there is unlikely to be a fiscal programme (e.g. Australia and New Zealand)
If a country is still looking to keep rates low, or even cut them further, and does not need to resort to a combination of fiscal and monetary stimulus, bull-market trends may be maintained. Both Australia and New Zealand fit into this category.
- Cross-currency positions
After a prolonged period of easy money, and then a collapse in the main export of several countries, there are bound to be national differences. If you add in the inevitable political uncertainty, there is scope for significant divergence in the performance of individual currencies. For example, we are concerned about the political and economic stability of the European Union and countries such as South Korea. On the other hand, the relative value of currencies such as the Australian dollar and Swedish krona are, to our mind, attractive if rates are no longer being cut and commodity prices are rising.
- Targeting companies that could benefit from an increase in infrastructure spending and tax changes
Investing in the relative performance of companies that are able to increase profits from the extra money that could be put into various infrastructure plans seems a sensible thing to do. Companies that benefit directly, such as cement companies, or perhaps indirectly, such as utilities, can be used to gain exposure to this changing trend in spending. Existing infrastructure companies, which could gain extra capital, could also be attractive from this perspective.
- Yield-curve positioning
As some countries move towards a mixture of loose fiscal and monetary policy, the corresponding rise in inflation expectations should tend to make the longer end much more volatile, while the front end is likely to be locked by the maintenance of low short rates. To anticipate this, we have switched out of longer-dated securities, and invested the proceeds in the middle part of the curve.
- Floating rate notes
In some countries, short-term interest rates will rise. FRNs have coupons that are directly linked to cash rates and therefore their income return will rise as well.
- Bank bonds
We believe steeper yield curves and fewer regulations, plus a better economic growth outlook, should help the profitability of banks and their bonds.
Inventive approach required
There is a continuing need to battle the negative effects of the credit crisis and high debt levels. The armoury in this battle is evolving – from the use of monetary policy alone, to the use of fiscal policy as an additional tool. We think a move towards a more volatile period in bonds is likely to unfold, in which market inflationary concerns could rise, and it’s our conviction that bond investors will need to be more inventive. We believe we have the tools to address the challenges – through a flexible-duration approach, and also by diversifying into a variety of uncorrelated sources of return.