4th November 2016 by Chris Iggo
The political turmoil over Brexit continues, the US presidential election race is as tight as can be and the European Union is living an existential nightmare. Monetary policy continues to be the main anchor for financial markets. Looking forward, if the growth outlook doesn’t improve and central bankers are running out of tricks, some dark political forces could be even more evident. Policy uncertainty will define the next phase of the post-crisis era. In such a world, my view would be to hang on to your bonds for income, protection and to provide the diversification we all need in investment portfolios.
What’s going on? – Trick or treating, parent’s evenings and the annual celebration of a failed Catholic insurgency (oh, and my birthday) are hallmarks of autumn being well advanced here in the UK. It’s a melancholic season in many ways what with the days rapidly shortening and leaf-shedding reaching its climax. It’s getting darker at both ends of the business day and reluctantly the heating has gone on at home. It’s also a time when, in this profession, we look towards the next calendar year, what it might bring and how we think investors will be able to navigate through financial markets. This is always a difficult exercise and the one thing we should have learned from 2016 is to never predict anything, least of all the future. It has been a year of shocks and they keep on coming. This week the High Court of the United Kingdom ruled that the British government did not have the authority to trigger Article 50 and thus begin the clock ticking towards the eventual withdrawal from the European Union. This adds further uncertainty to the outlook for the UK’s eventual relationship with the rest of Europe and suggests further political instability surrounding “Brexit” – making worse the feeling of “not knowing what is going on” for many investors, businesses and ordinary citizens alike. Perhaps there was always going to be a legal challenge to the referendum result, given that it was relatively close, but perhaps now, with the Court ruling, we may see more intense parliamentary scrutiny of the government’s negotiating stance on trade and free movement with the EU, prolonging the process for years. It’s either that or a quick hard Brexit, depending on Theresa May’s appetite for putting substance behind the “Brexit means Brexit” mantra. Either way there will be huge uncertainty in forecasting the UK’s economic performance in the years ahead. One rating agency has already warned that withdrawal from the single market will very likely lead to a downgrade.
Revolution – It could be argued that the political forces at work in the UK are also to be seen in many other countries. The narrative is around populism, defined in one way by the Oxford English Dictionary as “a label that covers disparate policies and passions: among many others, New Deal reforms, consumer rage against business, ethnic belligerence”. In its modern context the rise of populism is attached to the actual or perceived growth in income inequality since the financial crisis of the last decade, the real or perceived lack of any rise in living standards and the feeling that those who suffer the most from income inequality or stagnation have been let down by the “elites”. Increasingly and in many countries this manifests itself in anger directed towards official institutions – mainstream political parties, elected government, central banks, international organisations like the World Bank and the European Union and the machinery of the state – and towards private institutions – banks and big corporations. Worryingly the anger is also directed against ideas – globalization and free trade, immigration and tolerance, even capitalism itself. There is a blame culture and social divisiveness. In my view the risk is that unscrupulous demagoguery emerges to fill the political leadership vacuum. A political scientist could illustrate this line of thought by pointing to such examples as the Greek revolt against austerity in 2012, the rise of anti-mainstream parties like UKIP, Podemos and the 5-Star Movement, Brexit, the polarization of the American electorate and the belligerence of political leaders like Putin and Erdogan. The general lack of consumer confidence, distaste for “experts” and the disenfranchisement of the youth are perhaps other things we could say are symptoms of the post-crisis era.
Lookin’ for a Leader – When I look at consensus economic forecasts for next year I can’t really see the economic backdrop changing too much, thus I can’t see the political climate becoming more benign. Growth is forecast to be more or less the same as in 2016, perhaps a few tenths of a percentage point higher in the US and Europe, and inflation is expected to remain low on the whole, only higher because of either base effects from higher oil prices or where there has been an exchange rate shock. Surely if the Federal Reserve (Fed) thought that inflation was going to be sustainably close to 2.0% it would have raised rates by more than 25 basis points (bps) already. So if the baseline consensus is for the global macro outcome in 2017 to be more of the same, there will not be much change in the monetary policies. Beyond the adjustment that we have seen in bond yields in September it is hard to be overly bearish. In other words, unless the macro environment turns out to be much stronger, there is a limit to how high bond yields will go. Interest rates should stay extremely low and financial markets will continue to rely on leadership from the central banks. The idea that this leadership might weaken has already spooked European markets – note the sell off when it was suggested that the European Central Bank (ECB) might consider winding down its asset purchases. Indeed, in the spirit of considering the broader political-economic backdrop, it seems to really be only central banks that have delivered any consistent leadership since 2009. They have held the global economy together and, with it, many political relationships. A cynic might suggest that monetary policy has been one big sticking plaster covering the fatal wounds inflicted to market capitalism by the collapse of credit markets in 2008. The era of de-regulated financial markets and free flowing capital is over, or at least has become significantly changed over the last eight years. Regulation has become tighter, politicians and the public have turned against the kind of financial market activity that is thought to have brought the global economy to its knees and, as a result, investors have lost confidence in markets and financial institutions. Monetary policy has managed to keep returns going for a while but when central bankers admit they are coming close to running out of ammunition, the outlook for returns becomes less positive.
Get Up, Stand Up – So the context is a political environment where the consensus of the last thirty years is breaking down, a soft economic outlook and a diminished marginal impact from the only real policy tool that has been available since 2009. My fear is that there is a battle underway for political leadership which is tearing apart mainstream political parties and has been joined by a pretty disparate set of people that we would have thought to be on the fringe of acceptable social democratic politics. This means that the mainstream, when still in power, will consider a different set of economic policies to those they have relied on in recent years or that policy becomes much more unpredictable should non-mainstream political leaders gain power. We only have to note some of Donald Trump’s more outlandish policy proposals to see that this risk is real. The pressure from an electorate that feels disenfranchised from both the political and economic system is to do something different. There could be positive implications of this – more growth targeted fiscal policies, infrastructure spending, tax reform – but equally there could be policies that most economists would see as being bad for growth – reneging on trade deals, punitive tax increases in business and individuals, closing borders and challenging the independence of central banks. At the extreme the blame culture could endanger social cohesion and international relations in some cases.
Winds of Change – Political trends are slow moving but they are perceptible and that gives some reason not to be wholly pessimistic about the outlook. Social democracy and largely free market economics remain preferred ideals of the majority of western voters. Actually, growth is not that bad and recession risks are low. The recent purchasing manager data for October points to increased global manufacturing output and unemployment is low in the US and the UK and is falling slowly in Europe. Mainstream politicians could act to boost growth and incomes by utilizing the opportunity of very low long-term borrowing costs to boost aggregate demand. Better income growth and a perception of less inequality would go a long way to reducing the potency of populist political forces. The problem is we could get a messy outcome to the US Presidential election, the UK government could become a one-issue institution and the leaders of the European Union could appear to value defending purist principles on open borders and harmonization rather than jobs and prosperity. On this point the German election in the second half of the year and the French presidential election next spring will be extremely important to how European markets behave in 2017.
I need a dollar – So how should we look at bond investing going into next year, with the assumption that growth may continue to be similar to this year and inflation a little higher, but with all the political considerations noted above not far from the market’s attention? As always one should think about what bonds can offer – income, protection and diversification in a growth portfolio. Despite the low levels of yield there are still opportunities to focus on using bonds to achieve these ends. It is true that the income return from bonds has been diminishing consistently over recent years as interest rates have come down. Indeed, in many markets the balance of return in bonds has shifted towards capital gain and away from coupon return. That makes markets vulnerable when we consider the very basic fact that bonds mature at par. The longer duration parts of the market are where this imbalance is the greatest given the impact of quantitative easing. However, for income we can still look towards the high yield and emerging bond markets where coupon returns are still attractive. For example, the par weighted coupon on the US high yield market is 6.5% while the average price is 98.31. This compares to a US Treasury index where the coupon is 2.3% and the price 106.2. The combination of high price, low coupon and long duration make for very low yields to maturity in many parts of the bond market (take Italian BTPs for example) and these are not suitable for income investing at the moment. But short duration high yielding bonds can drive income oriented portfolios.
Gold – In terms of protection, bonds are intrinsically better suited to capital protection strategies than equities. But again we have to be mindful of the valuation of the market. Most bonds trade above par and thus there is inherent capital loss in a buy to maturity type approach. In that case the coupon needs to be high and the duration relatively short. Accepting what the yield is though, investment grade bonds have very low default risk and thus continue to provide capital protection. I would also include inflation linked bonds in a discussion about the protective characteristics of fixed income. If inflation does rise beyond the current expectations, index-linked bonds will perform well relatively to nominal rate bonds of the same maturity. Again, focus on shorter dated inflation linked in a period where CPI rates could easily double in the market economies. Index-linked are the gold of the bond market.
Just the way you are – Finally bonds do still retain properties that provide diversification in either a multi-sector bond fund or in a broader multi-asset portfolio. When it is important, the negative correlation between pure rates and pure credit spreads remains intact. When the economy is in a sharp slowdown or when markets are in a risk-off mode, rates fall (duration is a positive contributor to return) and credit spreads widen (negative contributor to return). Over the last ten years the correlation of returns from US Treasuries and the pure spread return from US high yield was -0.40 and between Treasuries and US equities, -0.30. Between European government bond returns and the excess return from European high yield, the correlation has been -0.15, and between UK gilts and UK investment grade credit spread returns and UK equities, the ratio has been between -0.10 and -0.20. Despite low yields, bonds should be used in a multi-asset portfolio to provide a hedge against negative returns to equities in down markets and to provide that little extra income in up markets. A simple 50:50 portfolio of US Treasuries and US high yield bonds would have delivered very similar returns to the S&P500 over the last ten years but with significantly lower volatility, meaning much smaller drawdowns. If the political-economic cocktail is to become more volatile going forward, then it is more important than ever to have diversification and the protective characteristics of bonds, despite the fact that yields are not attractive. Hopefully, they keep on rising going into year-end to make early 2017 levels in fixed income that bit more palatable.