Crises produce heroes. The greatest heroes of the COVID-19 crisis are the doctors and nurses fighting the disease on the front line. We also owe a debt of gratitude to all the key workers keeping essential services running. Within the financial sector, heroes are usually less often to be found, but I would like to suggest that Jay Powell, chairman of the US Federal Reserve (Fed), deserves praise for acting decisively and boldly, helping to prevent a sharp (but hopefully temporary) recession turning into a full blown financial disaster.
Unlike the White House, the Fed took action swiftly. As the COVID-19 crisis broke, Powell quickly deployed the economic tools that his predecessor Ben Bernanke had used during the Great Financial Crisis of 2008-9 (when the Fed did not act quite so quickly), and then he invented some more of his own. Again in contrast to the White House – which unfortunately now seems to be gearing up for an election battle focussed on racial conflict –, Powell has presented a consistent moral message: companies suffering in the downturn are not to blame, and deserve public support.
Financial markets’ growing understanding of the fierce determination of the Fed is behind the rally in risk assets (such as equities – company shares) during recent weeks. This rally is fully justified, in my view. Of course, as the lockdowns ease, there is a possibility that the coronavirus could begin to spread more rapidly again. A second wave of the virus would reignite fears of financial crisis – fears that badly frightened markets in March; but – make no mistake – this would again be countered by vigorous central bank action. Powell has established his credentials.
Government bond returns to suffer
There is a saying well-known to investors: “Don’t fight the Fed”. The US central bank, with its unlimited ability to print money, is too powerful to bet against, and investors should follow its lead. In response to the COVID-19 crisis, not only are the Fed and other central banks printing money, but governments have also embarked on massive spending programs.
This huge stimulus needs to be paid for. Given the new political landscape, the austerity measures of the past are unlikely to return. There is another way of ‘paying’ for so much spending: allowing inflation to rise, and to erode the future value of government debt. In my view, allowing inflation to take hold is likely to be more politically expedient than renewed austerity. The consequence for investors is that the real (after inflation) returns on government bonds will be very poor. Inflation is chronically bad for bonds – especially bonds with longer maturity dates – because it eats away at the real value of their future interest payments. So investors in government bond funds need to think again about their strategy.
Absolute return bond funds, unlike ordinary bond funds, target a return over cash while adopting a neutral position that does not contain sensitivity to interest rates. To produce returns over cash, managers look to short positions as well as hold long positions. Given the economic situation outlined above, I believe there is a clear opportunity.
There are plenty of ways to beat low future returns on government bonds: for example, by owning corporate bonds, inflation protected securities and currency unhedged foreign bonds. We can shrink the portfolio’s sensitivity to interest rates, if economic fundamentals start to pick up, by shorting long-maturity bonds.
Our absolute return process is designed around the ability to select investments from a very large universe globally and to have maximum flexibility in whatever investment environment we find ourselves in. Consequently, we don’t think you need to roll the dice with illiquid investments to get high returns.
Jerome Powell – like many heroes – is leading us into uncharted territory. He is right to do so, but long-only government bondholders need to watch out.