Portfolio Manager Nick Maroutsos explains why cooling global economic growth may lead to central bankers falling short in terms of policy normalisation and why a less synchronous economic cycle can create opportunities.
How would you assess global central banks’ path toward policy normalisation?
We believe that most central banks are being reactive – rather than proactive – to economic developments in their respective countries, choosing not to pursue policy normalisation for its own sake. This patient approach is merited as the global economy is more fragile than it seems. Several indicators point to slowing global economic growth and we consider inflation concerns exaggerated. Furthermore, the US Federal Reserve (Fed) tends to overpromise and under deliver with regard to meeting its targets. We expect that to be the case this time round as well. Should growth or inflation accelerate, central banks can always counter by
increasing the cadence of rate hikes.
Where might markets and central banks diverge on their views of the economy?
In growth environments, investors tend to jump on the bandwagon of expecting interest rate hikes and favouring risk assets. We, however, believe the Fed will not meet its inflation rate target for this year or next. The jury is out on the benefits of US tax reform and a step back from the global system of trade that has propelled economies forward over the last several decades is a threat that cannot be discounted. The Fed has rightfully focused on employment and inflation as it considers its path forward. But lately, officials have been quieter with respect to upward price pressure. In our view, central banks will not risk policy error by hiking interest rates too quickly. We expect US rates to remain range bound, and any move higher would be at a methodical pace. Keeping a lid on the upper end of this range would likely be yield-hungry non-US buyers, given the relative attractiveness of US Treasuries compared to other sovereign bonds.
How can bond investors achieve expected returns in a less accommodative environment?
We believe it is important to pursue attractive opportunities – with respect to geography and duration – regardless of benchmarks. The current investment environment looks favourable for an absolute-return mindset because different countries are operating in different economic cycles. While we believe the Fed will not move as quickly on interest rate hikes as it forecasts, Australia is firmly in the pause camp and could institute a cut. Given this environment, the flexibility to add duration in Australia, while exercising a more cautious approach in the US, is a tactic that investors unencumbered by the constraints of a benchmark could consider in their quest to lower portfolio risk. Venturing away from global benchmarks by limiting exposure to European corporate bonds may also be prudent in this environment. Yields in Europe, in our view, simply do not compensate investors for the political and economic risk they incur by maintaining an allocation to the Continent. With regard to credit, bond strategies that have chased returns down the capital structure belie the generally defensive nature of fixed income and are likely to provide little protection in a risk-off environment.
Policy normalisation – Central banks have engaged in unusual monetary policy since the financial crisis of 2008/9. This includes lowering interest rates near or below zero, and undertaking quantitative easing, which involves increasing the supply of money to directly purchase assets to help lower financing costs and stimulate the economy. Policy normalisation is a reversal of these unusually accommodative policy settings and a reversion to more normal policy.
Risk assets – assets that tend to perform better when economic and market conditions are more optimistic such as equities and lower grade bonds. A risk-off environment is when conditions are not favourable for risk assets and more defensive assets tend to perform better.
Duration – how far a fixed income security or portfolio is sensitive to a change in interest rates, measured in terms of the weighted average of all the security/portfolio’s remaining cash flows (both coupons and principal). It is expressed as a number of years. The larger the figure, the more sensitive it is to a movement in interest rates.
US Treasuries – another name for US government bonds.
Absolute return – the total return of a portfolio, as opposed to its relative return against a benchmark. An absolute return mindset is one more focused on delivering a positive return over time rather than trying to beat a benchmark.
Benchmark – a standard against which a portfolio's performance can be measured. For example, the performance of a UK equity fund may be benchmarked against a market index such as the FTSE 100, which represents the 100 largest companies listed on the London Stock Exchange. A benchmark is often called an index.
Capital structure – this refers to the ranking of the distribution of equity and debt in a company. Capital lower down the capital structure is most at risk of having to absorb losses if a company gets into difficulty.