16th February 2015
David Jane, manager of Miton’s multi asset fund range, explains why he has reduced exposure to bonds…
One of our most strongly held views has been our “lower for longer” theme. This is the thesis that, in view of unfavourable demographics and the ongoing debt overhang, we believe that growth, interest rates and inflation would remain lower for much longer than the market believes.
Our process looks for inconsistencies between what the facts are telling us, the data and what the market is saying, the narrative. Given the huge shift in bonds over the past months, it therefore pays to review the positioning through this lens.
Quite clearly the narrative has moved substantially over the past few months, as leading indicators of economic activity have weakened and oil prices have declined.
At the lows last week, 10-year UK yields were below 1.4%, market theory suggests that at this point we were discounting nominal UK growth over ten years of 1.4%.
We do not give much credence to market valuation theories. For example, our “new monetary economics” theme, which suggests we need to view markets through the lens of an interventionist policy. However, as an indicator of how far expectations have moved, it clearly shows a dramatic shift towards our based case, and arguably well beyond.
Considering this move alongside the data allows us to see the extent to which expectations have shifted. UK RPI inflation is currently 1.6% and real GDP growth 2.7% year-on-year in the fourth quarter.
Growth has been accelerating while RPI has recently been declining. The market clearly expects both of these numbers to decline markedly over the forthcoming decade, while this broad trend is in line with our view, current levels seem extreme.
At the same time the bond markets have been showing signs of extremes in a number of other ways. Fully $1.7tn worth of Euro area government bonds now have negative yields and Finland managed to issue a bond with a negative yield. Indeed there are quite a few short dated investment grade corporates now with negative yields. Strange times indeed.
Clearly we have entered the territory of the greater fool argument. It seems extremely farfetched to believe that investors would prefer the safety of government bonds when they offer the upside of a loss and the downside of a greater loss. That certainly does not feel safe in our eyes. We have heard arguments that it’s a positive real return or that yields could fall even lower given falling inflation expectations, but none of these really stack up when considering the potential return is negative to a long term holder.
Another worrying factor is the increase in the volatility of bonds. At current levels these supposedly low risk assets are now as volatile as equities. While their correlation with equities remains negative, for an absolute investor, risk has increased markedly while expected returns are at extreme lows.
Needless to say we have been reducing our fixed income exposure aggressively across our fund range, over the past few weeks, locking in recent gains, and, pending attractive reinvestment opportunities, the proceeds are being held in cash.
At the same time we have also reduced many of our equity positions which could be deemed bond proxies, notably the utilities. While it is difficult to call the top of any market, and we don’t generally attempt to do so, we are concerned that such extreme valuations could be quite a destabilising factor.