A few months ago I remarked to Jenna, my co-manager, how boring credit (corporate bond) markets were. Be wary of what you wish for I hear you say. US credit markets were displaying late cycle behaviour and we were cognizant of this. Merger and acquisition (M&A) activity was high and it was not an environment in which credit investors were getting well rewarded.
We had, however, a growing niggle, that global bond yields may keep falling against all the mainstream consensual thinking (yields move inversely to prices). Our main concern was, and indeed still is, the appalling global growth we have experienced post the Global Financial Crisis. Hands up, we like many, did not call the Brexit* result, but we keep coming back to the same conclusion — for the best risk adjusted returns in credit markets ‘buy quality industrial, large-cap, non-cyclical investment grade bonds’. We do not think this rather simple strategy will let you down. Let me explain.
Blinded by science
In 2010 we went short duration in our funds, in other words reduced interest rate sensitivity, partly due to overconfidence after a rather successful credit crisis, but also due to our orthodox university training in the dismal science of economics. Sterling fell very heavily in 2008, and yes we did import a lot of temporary inflation (consumer price index, CPI, growth reached 5.3%). The Bank of England saw through this and fortunately did not raise interest rates, as neither companies, nor individuals, had the power to pass these imported costs on, in higher prices or wages. I would suggest a not dissimilar outcome will happen again. Although the threat that a Brexit brings is very concerning for short term growth prospects, an advantageous major fall in sterling has been forced, which is the traditional escape valve in a flexible economy.
Behavioural responses to traumatic events matter
It was after reading Richard Koo’s book, The Holy Grail of Macroeconomics, in 2011, that we completed a volte-face in our duration thinking. Koo predicted that Europe would turn ‘Japanese’ nearly six years ago, and frankly he has nailed it. Our Japanese equity managers also warned us about this scenario many years ago.
Koo coined the phrase “balance sheet recession” — whereby individuals or companies, experiencing negative equity post a financial crisis, only want to pay off debt and delever (reduce debt). Thus, lowering interest rates is a completely ineffective policy tool. Koo is highly critical of the economics profession as it completely ignores ‘behavioural’ responses to traumatic events.
Many commentators have likened Brexit to bereavement — something I felt myself. Our macro outlook remains realistic, but fairly dismal regarding growth and inflation. Aside from Brexit, we have serious concerns about falling Japanese bond yields, the strength of the yen and the almost inevitable threat of a Chinese devaluation, which will bring yet another wave of deflation.
We have long been big fans of Larry Summers’ ‘secular stagnation’ theme. Brexit has exaggerated this view. In his most recent speech, the Bank of England Governor, Mark Carney, spoke about “economic post traumatic stress disorder” — whereby he expects individual agents and corporations to change behaviour due to the uncertainty of Brexit. In his words “EU exit would bring about major regime change”. Further, “The economic outlook has deteriorated and some monetary policy easing will likely be required over the summer.” So, Mr Carney seems to agree that major events result in behavioural changes.
The BoE to do its bit
We expect interest rates to fall by 0.5% very soon. We also expect a corporate bond buying programme and cheap funding schemes for the banks. On July 1, some of the bank capital requirements for UK banks were loosened. Carney also talks about ruthless truth telling, implying that monetary policy alone can only have limited effects.
Thus, we expect a major fiscal response to the UK’s predicament, and only wish our European counterparts would follow a similar route, but they are unfortunately constrained by the ridiculous Maastricht Treaty**. Fiscal expansion has been tried in Japan of course, but with limited success — they did not undertake the necessary structural reforms — which Koo estimated could account for 80% of the heavy lifting — alongside economic reforms.
Our ‘global titans’ strategy
Throughout last year, we suggested investors should not be tempted to ski off piste in the afternoon sun. That is, getting hoodwinked into such things as overly levered structured products, peer to peer lending, Chinese property investments, small cap lending, aircraft leasing and private placement to name a few. In addition, we materially reduced our high yield (but short duration) book in favour of long dated (high duration) US investment grade credit.
We continue to favour the refreshingly simple; reasonable to high credit quality names, but with the long duration attributes of investment grade credit. We have focused entirely on large cap, non-cyclical, consumer facing, ‘reason to exist’ credits such as Kraft Heinz, Boots Walgreen, Philip Morris and Verizon.
Why? Because in 30 years’ time these companies will still be paying reliable, dependable coupons to their bondholders. If anything, we may pursue this global titans/nifty fifty*** strategy even further. We continue to avoid the heavy cyclicals such as shipping, mining, autos and chemicals.
Expect investment grade bonds to party on
Bonds returns will be all about ‘income’ in the future. We want to lock this in as long as possible. We expect bond yields in the high yielding countries of the UK and the US to fall further, and believe their yield curves will flatten even more as European, Japanese and Asian investors seek out yield. We expect investment grade bonds to party on as the global grab for yield continues. We generally favour going along the corporate bond curve to better quality credit rather than going down the credit curve to lower quality.
To put it another way, at the margin we continue to prefer duration risk over default (credit) risk. It’s as simple as that.
*Brexit: UK’s decision to leave the European Union.
**Maastricht Treaty: also known as the Treaty on European Union, signed in February 1992.
***Nifty Fifty: here refers to large-cap corporations that are regarded as solid and stable over long periods of time.