John Pattullo Co-Head of Strategic Fixed Income | Portfolio Manager
Jenna Barnard and John Pattullo, Co-Heads of Strategic Fixed Income, share their thoughts and views on bond markets in the coming year. As they see it, the key question for 2020 is whether the decline in economic growth and inflation will come to an end and whether we get an economic ‘soft’ or ‘hard’ landing. They believe the US dollar’s performance holds the key to the outcome, as it is unlikely to get reflation without a structurally softer dollar.
Bonds can be good diversifiers for portfolios and equity risk as they react to changes in economic growth and inflation.
The Strategic Fixed Income Team entered 2019 with a non-consensual view that bond yields and interest rates would stay low for a very long period of time. Though that view has not changed, the consensus has now come round to their view of the world. The key question for 2020 is whether the decline in economic growth and inflation is now coming to an end.
John and Jenna examine endless charts for indications of future trends. One chart that could be a key indicator of the shape of things to come in 2020 is that of the US dollar’s performance, as they believe the necessary requirement for a sustained reflation is a structurally lower dollar.
Where do you see the most important opportunities and risks within your asset class in 2020?
Jenna Barnard: When you think about the opportunities and risks with bonds, what you need to understand is that they are a relatively simple asset class. Government bond yields and interest rates follow the rate of change in growth and inflation. For the last 12 months, bonds have done a great job diversifying portfolios and equity risk, and as growth peaked, and inflation peaked, bond yields peaked around the world.
So going forward from here into 2020, the question is now whether we are bottoming out in terms of the decline in economic growth and inflation. That is the debate that has been happening since September. There are initial signs that the manufacturing cycle may be bottoming and, that the rate of change in growth and inflation may begin to pick up. In which case, bonds will have a tough time as you would expect. As I said, they are a simple asset class and they diversify a portfolio because they react to the rate of change in economic growth and inflation.
Are there key themes that are particularly relevant to your strategy?
John Pattullo: I think the key trend of this bond strategy that we run is that we try to make bond funds behave like bond funds. We would try not to provide any surprises to the clients and hopefully they know our philosophy and, our strategy and are not given surprises.
I think we believe quite passionately in active asset allocation. So we are not a slave to gilts, or sovereign bonds; we are not a slave to investment grade; we are not a slave to loans; we are not a slave to high yield. We can vary the interest rate sensitivity and the credit sensitivity — independent of each other — to achieve good, long-term, reliable, returns for clients. I think it is also important that we do focus very much on the downside risk — so we don’t want to have big drawdowns at any time, and that is something we focus very heavily on. And I think that really chimes with our stock selection, which we describe as sensible income. We tend to invest in large‑cap, non-cyclical1, reliable, quality businesses and, over time, we found that they don’t let us down.
How have your experiences in 2019 shifted your approach or outlook for 2020?
Jenna Barnard: We actually had a non‑consensual view on bond yields and interest rates. We thought they would stay low for a very long period of time. We never agreed with the consensus that bond yields and bond markets were a bubble and 2019 has confirmed that. If anything, consensus has come round to our view. You’ve heard ‘Japanification’ talked about ad infinitum and, central banks globally have also begun to shift their reaction function2. So they are now saying that the biggest challenge is that inflation is too low and has been too low since 2009. You heard that from the Federal Reserve in the US particularly. Very different to 18 months ago, when they thought inflation taking off would be the biggest challenge.
So, I wouldn’t say we’ve changed our philosophy or approach, but it is interesting that consensus has now come round to our view of the world.
Is there a particular ‘chart to watch’ as a key indicator for change in 2020?
John Pattullo: The irony is that we spend our lives looking at endless charts and what we do is a lot of work to see if there is confirmation between different charts, between different asset classes; whether they corroborate existing views and evidence — or contradict. Because sometimes they can obviously contradict. But I guess the main one in my mind really is the strength of the dollar.
There is obviously significant debate as to whether we are in a soft landing and it is mid‑cycle, or whether we are in a hard landing and it is late‑cycle. The first case is more an equity view of the world and the second case is more of a bond view of the world.
What I think can be said, and this is the ‘tell’ if you like, it is unlikely to get a significant soft landing and a reflation, unless you have a soft dollar. That is a pretty important point. Against that we look at endless charts, of which many are important, but I think the important ones are oil (general proxy for demand), shape of the yield curve3 (of course we do, we are bond people!) and money supply and growth I think are probably the most topical ones and, financial conditions. I could give you a hundred more to be honest but really the dollar is the ‘tell’ and that’s the one which I think, in my opinion, is really significant.
1Non-cyclical: companies/industries that provide essential goods such as utilities or consumer staples. While cyclical businesses produce goods and services that consumers buy when confidence in the economy is high, non‑cyclicals produce items and services that consumers cannot put off regardless of the state of the economy such as gas, food and electricity.
2Reaction function: a general market terminology for the way in which a central bank adjusts it policies.
3Yield curve: a graph that plots the yields of similar quality bonds against their maturities. In a normal/upward sloping yield curve, longer maturity bond yields are higher than short-term bond yields. A yield curve can signal market expectations about a country’s economic direction.
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