Strategic Fixed Income: Japanification — Europe first and now the US
John Pattullo Co-Head of Strategic Fixed Income | Portfolio Manager
John Pattullo, Co-Head of Strategic Fixed Income, explains how the suppression of volatility by the US Federal Reserve during the Covid crisis has led to the Japanification of the US corporate bond market.
Just as we saw in Europe, Japanification — which refers to Japan’s experience of persistently low interest rates, low inflation and low growth and where the central bank has completely supressed volatility — has now spread to the US and, at a remarkably faster pace.
As was the case in Japan, the US central bank’s suppression of volatility, together with its backstopping of investment grade (and, to a lesser extent, high yield) bonds, has created an almost idyllic environment to invest in corporate bonds.
With the collapse of the sovereign yield curve in the US, there have been large inflows into the US corporate bond markets in recent months, with overseas buyers as the major participants. Interestingly, given the unending search for yield, quality, well‑known investment grade names are now almost the new sovereign bonds or the new benchmark rates.
I thought I'd give you a brief update on our team's thinking.
Now, HSBC coined the phrase ‘the decade of denial’, which really is the lower for longer, lower inflation, lower growth and lower bond yields, which many people deny, especially in America, less so in Europe. We've been of that view really from 2013 when we started speaking about Richard Koo's [from Nomura] secular stagnation thesis. Now the Covid crisis, we didn't anticipate, nor the oil crisis. But of course, we are not surprised by the direction of travel of bond yields. We are a little surprised by the pace of travel.
Japanification has spread to the US
Now, the Japanification of Europe was a big theme and that's played out well for us and for our investors. We think that's really spreading and has spread to the American corporate bond markets. If you look at Japan, what the central bank has really done is completely suppress volatility. That is almost ideal, an idyllic environment for investment grade corporate bond investing. Compounded by the [US Federal Reserve] Fed backstopping investment grade and, to a lesser extent, some high yield default risk with the purchase of corporate bonds in investment grade and high yield. You combine that with a massive, almost a desperate search for yield — you know, I've been doing this for 20 years now and all I've really heard, is give me reliable, sensible yield.
Unusually big inflows and fairly limited inventories
So, what we've seen is a lot of supply and Nick [Ware] has written a recent article saying that bond glut has really been moving to a bond drought and that's a topical piece. The suppression of volatility, the underwriting of systemic risk, and investment grade is really a systemic asset class, driven by VIX volatility and to a lesser extent, default probabilities.
In addition, you've had big inflows, as I spoke about, and fairly limited inventories in the street and overseas buyers have been a big participant in the American corporate bond markets; because as interest rates have come down, the hedging back to local currency costs have come down. So actually, we think corporate bonds in America are actually pretty cheap in a relative, international, scale and that desperation for yield, we think, will only continue. Look to Japan, the evidence is in Japan, the suppression of volatility, lower MOVE and VIX indexes suggest volatility has been suppressed by the central banks. That's a great environment for corporate bond investing.
In some ways, the quality, sensible income names are really almost the new sovereign bonds, almost the new risk free rate. Well‑known names are almost the new sovereigns, the new benchmark reference rate, because the sovereign curve has completely collapsed. This is exactly what we saw in Europe and is exactly what is playing out in America and, if anything, it is playing out remarkably fast. But still, we think some people remain underweight bonds and the flows are really massive and almost terrifying, even though I've been doing this a long time.
Recent thoughts and research from the team
Finally, I'd like to highlight some of the research the team has recently done. I wrote a piece, ‘So what about inflation?’ And I think people shouldn't confuse inevitable, cyclical, uptick in bottlenecks and price volatility in commodities and lumber and gold and copper — a cyclical breakout — with a secular or structural shift; and that will probably be the debate next year. I mentioned Nick's article ‘From bond glut to bond drought’, and then Jenna [Barnard] and Nick have also written a new piece recently about the break in the link between GDP declines and default rates.
Default rates in America will be higher because the constituents of the index are generally worse and there are less government bailouts. Whereas in Europe, we think default rates might actually be quite low — zombification of names but massive government support. Germany, for example, has put almost three billion [euro] via various agencies into TUI. They put nine billion [euro] into Lufthansa and, there's a lot of socialisation of risk in Europe, unlike in America. And that's an interesting divergence.
So, to summarise, we remain pretty bullish. Corporate bond spreads, they have come a long way, but that suppression of volatility, like what happened to Japan, is the main point.
Thank you very much for listening. If you've got any thoughts or questions, please contact your local salesperson. Thank you.
Note: the government bailout of Lufthansa amounted to US$9.9 billion, or €8.3 billion at the 14 August exchange rate.
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