Heatwaves eventually end in thunderstorms. Some people think that the current investment cycle will end in a big storm. Indeed, I get the feeling from what I read and hear that some would actually welcome an abrupt end to what has been a frustrating period for many. Rates haven’t gone up much, inflation remains subdued, volatility is low and economic growth continues to rumble along at a decent pace. This has done for investors that positioned for a less benign outcome. It’s likely that the great “cleanse” is not going to come. So instead, a diversified beta approach to investing should continue to deliver slow and steady returns. In fixed income that means focus on carry, enhanced yield opportunities when they come, inflation protection and a big enough exposure to safe assets like government bonds to hedge when risk has one of its periodic wobbles.
Feel the heat
Wow it’s been hot. In the last two weeks I’ve been in Hong Kong, Cornwall, and London and it’s been hot everywhere. Thank goodness for a sea breeze, air-conditioning, and the occasional typhoon rain shower. Next week I will be on holiday in the Balearics so hoping the fine weather continues – it’s easier to deal with wearing beach shorts and sliders than being on the tube in a suit. Before I down tools for a couple of weeks I thought it would be a good idea to review where we are regarding issues that might impact on bond markets during the remainder of the year. Will the final five months of the year bring anything different or will the combination of low volatility and low yields prevent fixed income returns even keeping pace with inflation? I suspect that the approach I have favoured so far in 2018 – having a barbell of long duration as a risk hedge and looking for yield enhancing opportunities – is likely to be a sensible way forward.
I am not sure that the referendum on UK membership of the European Union really reflected the UK electorate’s considered opinion on trade deals, the Irish border question, security, citizens’ rights, the ability of British pensioners to continue to receive payments to their homes on the Costa Del Sol, and co-operation in education and scientific fields. As we approach the March 2019 deadline for leaving, the mood music is not great in that there is a renewed campaign for some kind of second referendum and the UK government has yet to convince even its own party that the country is on track to securing an optimal deal for the UK, its economy and its people. But all along, Brexit has not been demonstrably a market event. Sterling is lower than it was before the referendum – but not by much and it is now stronger, on a trade weighted basis, than the immediate post-vote level. Gilts have range-traded since late 2016, more influenced by inflation and the Bank of England than the political circus around Brexit. UK equities have underperformed, that is true, but they are still higher. However, economic growth, measured by GDP, has fallen since the referendum. Growth in GDP was stronger in the two years prior to the referendum than it has been since. This is in a period during in which global growth has been quite buoyant. Looking at the breakdown of GDP growth, government spending has been a major weakness (although stock-piling food and other essentials should add to GDP in coming quarters) and, perhaps more worryingly given the supposed buoyancy of the labour market, household spending growth has slipped. The outlook is highly uncertain because we don’t know what the relationship between the UK and the EU will look like yet. In the meantime, the EU has been making trade deals with Japan and the US. It’s hard to see growth accelerating at this stage, particularly given the uncertainties. Gilts might not be a bad asset to hold for UK investors even with a yield of 1.27% at the 10-year level. The risk is that sterling would take the brunt of any perceived bad deal for the UK. Ultimately that may be to the benefit of the UK, but for a period, currency weakness and a collapse of business and household confidence would not be supportive for domestic UK equities.
President Trump is the gift that keeps on giving. I am sure he has a list of “things to do” above his bed which he ticks off now and again – Mexican Wall, tax cuts, getting a better trade deal for the US….and so on. The bottom line is that he is a business man and he wants the best of USA Inc. Thus ultimately he will probably deliver lower taxes on trade to add to lower taxes on income and investment. Yet at the same time his comments can provide enough noise to create bouts of volatility in markets – in oil markets, in the Amazon share price, in the foreign exchange rates of the dollar. The noise is loud and it is hard to identify the signal but the signal is very much in favour of free market economics. When we think about the length of the US business cycle so far, it is not popular to think that it could be extended because of Trump especially if inflation and interest rates remain relatively low. For markets, stocks could keep moving higher and, despite the recent tweets on currencies, I think this is positive for the US dollar. Let’s be clear, aside from an external shock that craters business and consumer spending, the US economy can continue to grow until the Federal Reserve (Fed) takes real interest rates above the neutral rate. With inflation at 2.3% (core) that means quite a bit more tightening of monetary policy. Recessions don’t happen just because there is an uncouth man in the White House.
Which brings me to US (or should I say global) interest rates. The Fed is on track to raise rates a few more times and probably has another 75bps – 100bps to go before the Administration gets really upset with monetary policy. At the same time the yield curve is fairly flat and a lot of Bloomberg TV chat is about the signalling property of an inverted yield curve and what that means for the economic outlook. I think the key is inflation. If inflation does not raise any further, then we will get to positive real interest rates a lot sooner than would be the case if inflation was higher. Long-yields have moved up again over the last few weeks but the 10-year Treasury yield remains below 3%. My view is that there are a few reasons that bond yields remain relatively low. One is inflation stability. The second is that all the “rates geeks” in the bond market have been spending a lot of time reading Federal Reserve research papers on the real neutral rate – R*. This is an incontrovertibly unobservable phenomena. So it tickles me to death that so many bond people have such strong views about it. The consensus is that it is very low (real neutral rate between 0% and 1%) so the Fed does not have much more to do before it gets into restrictive territory. I can argue passionately that Manchester United are the best team in the English Premier League but if they don’t end up as champions I am wrong. There is no way to conclude on whether estimates of R* are right or wrong – and never will be. Yet is has become the received wisdom (and therefore a behavioural thing) that the Fed is flirting with overdoing it on interest rates. What I am trying to say is that there is a belief that 10-yr yields don’t need to be above 3% because the long-term average short term rates will be significantly lower than that. So in this cycle, the only way the curve steepens again from here is if inflation picks up. Better to have US break-evens as an option on this rather than being short duration in case it happens. Having said all that, US investors face a fixed income market that should continue to outperform, largely because yields are higher.
Real rates are very negative in Europe. Indeed this is mostly because nominal rates are negative. This is a concept that still makes my head hurt. A lends some money to B, and instead of B paying A some regular amount of interest, B instead either receives a periodic payment from A or deducts an amount that B owes to A from the principal. If I can borrow 100 from someone and only need to pay them back 99 and at the same time lend the 100 to someone that will pay me back 101, then I make 2%. The question is, are there enough positive return opportunities in Europe to generate enough wealth creation (economic activity) to stop that particular policy anytime soon? Draghi is betting that, on balance, it has worked. But his confidence is not that strong given that rates aren’t going to be increased before next summer (and, if it doesn’t work, he won’t be there anyway)! In a closed system, negative interest rates are wealth destroying (A lends 100 to B, B pays back 99 to A, A lends 99 to C, C pays 98 back to A…). They can only work if the provider of the “seed” capital is a central bank that can print money and (ambivalent to loss) there is enough going on to generate productivity driven real returns. Borrowing negative rate money to invest in the Italian government bond market does not seem to be either a safe way to generate wealth or anything that creates long-term economic growth. Meanwhile, savers are punished because real returns on safe assets are negative. I worked in private wealth for one part of my career. The benchmark there is preserving the real value of capital. German bund total returns are 1.34% so far this year, European high yield returns are -0.19%. Consumer prices at the aggregate Euro Area level have risen by 1.2% so far in 2018. Most European stock markets are showing a negative total return since the beginning of the year. Hard to argue that European monetary policy is wealth creating. Hard to see anything changing there in the rest of 2018.
Where will it end?
There is a kind of death wish amongst some commentators in the market. A kind of expectation that something bad is coming down the pipe that will “cleanse” markets from their reliance on cheap money and over-hyped tech. I think this comes from the fact that, despite the business cycle still expanding, it has become more difficult to make money in traditional asset classes like bonds and equities. Once the crash happens, the decks will be cleared to start making money again, so the narrative goes. I have been guilty of such thoughts, hoping rates would go a lot higher causing a widening of risk spreads and cheap valuations. Rolling volatility shocks, political chaos and quantitative tightening are seen as storm clouds gathering. The longer the cycle goes on, however, the more frustrating it gets for some investors. Running a negative duration strategy is an example of forecasting something bad that only results in bad performance. Betting on a Chinese hard landing or a collapse in US high yield are others. My view is that the business cycle is not coming to an end this year and that market conditions are not going to change significantly. Populism will remain the dominant political narrative and that will keep people worried. The real return on safe assets (the anchor of the capital markets line) will remain low so returns from anything else are probably going to be disappointing. Sentiment is likely to be more volatile than the underlying economy. A diversified investment approach remains the best way to be positioned. Market timing, as a strategy, is not likely to consistently work in such an environment. Most return will come from beta but that return itself might continue to be low, so better to diversify your sources of beta in a sensible way. Because there is uncertainty about how the cycle evolves from here (growth, inflation and interest rates), a portfolio that can benefit from a prolonged earnings cycle (US S&P reported earnings growth in the current season so far is 24%), may gain/be helped by some carry from a still benign credit cycle, a little inflation protection and some long-duration for those periods in which pessimism prevails is likely to do better than one that is tilted by a conviction about precisely where were are in the global business cycle.
Belated congratulations to France for winning the World Cup. It was an enjoyable tournament and I enjoyed watching the final on the open terrace of a pub in Cornwall, with the Fal River as fantastic backdrop. We have a brief respite from football for a few weeks before the regular season gets underway. Jose Mourinho seems to be downplaying Manchester United’s chances of challenging for the title, but if Pogba can replicate his World Cup form we have to be in with a serious shot. Thankfully, Sir Alex Ferguson will be in the crowd at Old Trafford once the season gets underway, having posted a public message this week confirming his solid recovery from his brain operation in May.