Strategic Fixed Income outlook 2020 — no reflation without a soft dollar
4 minute watch
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.
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.
Please read the following important information regarding funds related to this article.
- An issuer of a bond (or money market instrument) may become unable or unwilling to pay interest or repay capital to the Fund. If this happens or the market perceives this may happen, the value of the bond will fall.
- When interest rates rise (or fall), the prices of different securities will be affected differently. In particular, bond values generally fall when interest rates rise. This risk is generally greater the longer the maturity of a bond investment.
- The Fund invests in high yield (non-investment grade) bonds and while these generally offer higher rates of interest than investment grade bonds, they are more speculative and more sensitive to adverse changes in market conditions.
- Callable debt securities, such as some asset-backed or mortgage-backed securities (ABS/MBS), give issuers the right to repay capital before the maturity date or to extend the maturity. Issuers may exercise these rights when favourable to them and as a result the value of the fund may be impacted.
- If a Fund has a high exposure to a particular country or geographical region it carries a higher level of risk than a Fund which is more broadly diversified.
- The Fund may use derivatives towards the aim of achieving its investment objective. This can result in 'leverage', which can magnify an investment outcome and gains or losses to the Fund may be greater than the cost of the derivative. Derivatives also introduce other risks, in particular, that a derivative counterparty may not meet its contractual obligations.
- When the Fund, or a hedged share/unit class, seeks to mitigate exchange rate movements of a currency relative to the base currency, the hedging strategy itself may create a positive or negative impact to the value of the Fund due to differences in short-term interest rates between the currencies.
- Securities within the Fund could become hard to value or to sell at a desired time and price, especially in extreme market conditions when asset prices may be falling, increasing the risk of investment losses.
- Some or all of the ongoing charges may be taken from capital, which may erode capital or reduce potential for capital growth.
- The Fund may invest in contingent convertible bonds (CoCos), which can fall sharply in value if the financial strength of an issuer weakens and a predetermined trigger event causes the bonds to be converted into shares of the issuer or to be partly or wholly written off.
- The Fund could lose money if a counterparty with which the Fund trades becomes unwilling or unable to meet its obligations, or as a result of failure or delay in operational processes or the failure of a third party provider.