John Pattullo, Co-Head of Strategic Fixed Income, discusses how the markets were affected by major political events in 2016 and the lessons learnt. As he looks forward to 2017, John shares his views on what themes are likely to dominate the markets given a volatile backdrop and where he looks to find good investment opportunities.
What lessons have you learned from 2016?
2016 has been an interesting year and we have learnt two main lessons. Firstly, that these days no one can predict the outcome of a poll! More interestingly and related to this, was the monetary1
responses to the two big events — Brexit and the US presidential election. Brexit produced a monetary policy response, as the Bank of England cut interest rates; and while sterling fell sharply, sterling bonds benefited as yields fell and prices rose. In the US, with the election of Donald Trump the opposite was proposed — a fiscal response; the US dollar rose sharply while the bond markets witnessed a sell-off as yields rose. These two events have, however, taught us that we will have opportunities to exploit in the upcoming elections in Europe in 2017.
The second lesson was on ‘liquidity’. In the last year we have significantly increased our holdings of US investment grade3
corporate bonds. Following the surprise election of Trump, in order to protect the portfolios, we took steps to reduce duration (interest rate sensitivity) and were able to sell roughly US$400m of bonds in just two days in the US investment grade market. The transactions were done in an efficient way due to the sheer size and liquidity of this market. That could not have been possible in our traditional hunting ground, the sterling corporate bond market, which is relatively small in size. Thus the need to be in liquid, sensible names that we can easily trade, became ever more apparent. We found that having more pools of liquidity available to us — in US dollar, euro or sterling; government, investment grade, or high yield4
bonds, and loans — proved beneficial at a critical time.What are the key themes likely to shape the markets in which you invest in 2017?
In recent weeks, prior to the US presidential election, equity markets were experiencing a small ‘reflation’ rally, as economic data seemed to suggest a return of modest growth and inflation in some parts of the world. We have spoken about this in our videos and articles; but the election of Trump pushed the theme far and wide, with more investors rushing to switch from defensive/expensive stocks into cyclical stocks such as financials, while bond markets sold off.
We believe there is a possibility that the reflation theme might fade by the middle of next year. This is because we are not convinced, and nor are the strategists that we speak to, that Donald Trump can invigorate the US economy meaningfully to justify the very large price moves that we have seen in both the equity and bond markets. We may go back to the deflationary5
, secular stagnation6
themes that were prevalent in the bond markets; or secular stagnation with an extra dose of ‘stagflation’7
, potentially, next year.
The other big theme is politics, in particular the French and German elections. These could turn out to be big events, and are thus a big focal point for the team. While there could be obvious threats to the European project, we foresee opportunities arising for investment, based on our experience this year in trading some of the election risks and the strategies around them. In fact, there are always things to be doing in the markets and that is what makes them so interesting. What are your highest conviction positions moving towards the new year?
Secured loans continue to appeal to us and we have reasonably large allocations to this asset class in the portfolios. They are senior, first lien secured (in the event of a default, the lenders will be first to receive repayment from the liquidation of the company’s assets), pay floating interest rates (thus have reduced interest rate sensitivity) and benefit from low volatility, while providing a reasonable yield.
We also like US high yield bonds, where we believe company default rates will remain low. Specifically, domestic facing, large, non-cyclical8
businesses with reasons to exist, that have shorter durations and offer reasonable coupons (interest income).
Finally, we favour some investment grade corporate bonds, and a number of big global banks. We are wary of emerging market corporate bonds, where the going will be tough given a Trump presidency, and European investment grade bonds given their very low yields. We will consider longer-dated investment grade bonds subject to the reflationary and deflationary themes washing through the world.
In short, a lot of loans, high yield and a sprinkling of investment grade.What should investors expect from your asset class and your portfolio(s) going forward?
Trump has made the bond manager grumpier! It will be a tougher environment for bond managers and probably an easier one for equity managers. While no one knows for certain, it is possible that the situation might reverse by the middle of 2017.
In the short term, it looks like a tougher outlook for bond managers as there will likely be a little more growth and a little more inflation (which erodes the value of most bonds).
That said, we are happy if we can achieve the running yield (total return) of the funds (roughly 4%) for our clients. We believe there will be good opportunities next year where we can use both long and short duration strategies9
once again to the benefit of the portfolios. In summary, we are going to keep liquid, sensible, and look for opportunities, but not force it.
- Monetary policy: the policies of a central bank, aimed at influencing the level of inflation and growth in an economy. It includes controlling interest rates and the supply of money.
- Fiscal policy: government policy relating to setting tax rates and spending levels. It is separate from monetary policy, which is set by a central bank.
- Investment grade: companies that are deemed less risky by credit rating agencies, as they believe there is a strong likelihood that the company will be able to repay its debt.
- High yield: companies that are deemed to have a higher risk of default on their debt by credit rating agencies, who assign them a lower credit rating than investment grade corporate or government bonds. To compensate for the increased risk, the debt of these companies pay a higher yield.
- Deflation: a sustained fall in the prices of goods and services, and thus the opposite of inflation.
- Secular stagnation: excessive savings act as a drag on demand, reducing economic growth and inflation.
- Stagflation: a relatively rare situation where rising inflation coincides with anaemic economic growth.
- Non-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.
- Short and long duration strategies: duration is a measure of the sensitivity of bond prices to changes in interest rates. Bonds with longer maturities and therefore higher duration experience greater fluctuations in their value, falling more in a rising interest rate environment, and vice versa. If interest rates are expected to rise in the future, a portfolio manager would aim to reduce the average duration of the portfolio (go short duration). This could be achieved by simply increasing exposure to shorter maturity/duration bonds, or by using derivatives. Alternatively, in a falling interest rate environment, the manager would extend duration (long duration).