After a number of false starts, major central banks appear finally to be in the process of scaling back the extraordinary measures they have sprayed at markets in the wake of the global financial crisis. We are positioning our portfolios for the moment when markets dry themselves off.
It is instructive to recall how the crisis began surging savings in China and by baby boomers stoked an explosion in consumer debt in the West, abetted by reckless lending, which triggered the subprime mortgage crisis. The European debt crisis followed not long afterwards.
Developed-market central banks, led by the US Federal Reserve (Fed), responded by slashing interest rates and purchasing assets; some countries doled out hefty fiscal stimulus, too. What ensued was a consumer-led recovery, in which government deficits ballooned and investment spending by companies shrivelled.
At the same time, rising globalisation and automation helped to depress wages, pushing inflation lower – as did declines incommodity prices and the persistence of large output gaps.
A TOXIC MIX
Yet there was one area where inflation was particularly conspicuous: asset prices. Bonds and equities have marched higher almost in lockstep since early 2009, supported by low interest rates; quantitative easing; low wages, inflation and capital investment; and strong corporate profits.
Unsurprisingly, this mix has proven politically toxic. Pressure points are now forming as voters tire of the fruits of the recovery being spread unevenly, corporate debt grows a pace and policymakers show concern over future financial stability. Indeed, financial conditions remain very easy even as the world economy enjoys a cyclical upswing –the Fed has demonstrated little control over the yield curve.
The Fed is now once again leading the pack of developed-market central banks in gradually reversing accommodative policies. The European Central Bank is likely to follow suit – if not immediately in raising interest rates then at least in tapering its asset purchases, for the simple reason that it is running out of bonds to buy.
Taken together, this all suggests bond markets will re-price lower over the near- to medium-term, in our view. Asset prices are more at risk here than the business cycle.
WHEN THE MUSIC STOPS
How is this likely to play out? We expect bond yields to rise and credit spreads to widen. A return of the term premium –essentially the excess yield investors require to hold a long-term bond instead of a series of shorter-term securities – is also probable.
In addition, the equity and housing markets may struggle under this scenario.
As such, we expect volatility to increase and see emerging-market assets, high-yield credit, REITs and some mutual funds being impacted by occasional bouts of market illiquidity. Such a backdrop is likely to play to the strengths of active managers over passive investment products, in our view.
This process need not be chaotic and particularly bruising for investors. But there is a chance that the re-pricing of bond markets will be disorderly, sparking a rapid tightening of financial conditions and casting fresh doubts over the economic progress of those nations with high debt-to-GDP ratios, such as the UK.
It could also threaten the economic recoveries of countries like Australia, whose consumers and housing markets have only known an easy-money world for decades.
We favour a stance that would benefit from the gradual normalisation of policy, alongside positions that would gain from a more adverse scenario for risk assets. As such, we see value in shorting developed-market rates to take advantage of rising yields, and shorting Italian government bonds as markets re-price without the cover of quantitative easing.
We also see value in curve-steepeners in developed-market debt, to express our view on the term premium and position for rising inflation.
With regard to emerging markets, we like certain assets of countries whose economic fundamentals suggest resilience in the face of swift shifts in capital flows. However, we prefer to avoid such assets in the near term, in order to ‘buy the dip’ when it comes.
Elsewhere, we favour selling the Swiss franc against other European currencies, as the Swiss National Bank is likely to keep its policy rates at punishingly low levels and safe-haven flows may go into reverse.
THE VERY LONG GAME
Over the long term, after the exit from extraordinary monetary accommodation is well underway, we expect a different set of circumstances to take hold, when investors will recognise that baby boomers and China continue to dominate asset price levels and income distribution.
Then, as now, we believe it will be crucial to act nimbly across the global fixed income universe to exploit the opportunities and sidestep the risks.