Why invest in bonds
03 March 2017 | Markets and Economy
Paul Malloy, Vanguard's head of fixed income, Europe, and Alexis Gray, Vanguard economist, answer questions on the outlook for the economy and the best response for bond investors.
Leo Schulz (moderator): Why invest in bonds? Are we returning to an inflation-prone economy, how far and how fast might interest rates rise, and if they do, what should investors do to protect themselves from a fall in the value of bonds? My name is Leo Schulz. To help answer these questions, I have with me Alexis Gray, economist, and Paul Molloy, head of fixed income, both here at Vanguard Europe.
Just before we start I should mention that Vanguard is holding a series of workshops on fixed income around the UK, starting on 7 March and continuing into the summer. They are proving extremely popular, so if you haven't done so already, and you'd like to go, I would urge you to book your place sooner rather than later. Contact your Vanguard representative or call 0800 9175508 or email firstname.lastname@example.org. The workshops will be worth ninety minutes towards your 2017 CPD.
We don't have a lot of slides; I'm keen to concentrate on what Alexis and Paul have to say so we've kept the agenda very simple: one, are we back to an inflation-prone economy, and two, if so, what is the implication for fixed income investors?
Alexis, just looking at this slide, sterling interest rate expectations - what's the key point here, what are we looking at?
Alexis Gray (Vanguard economist): What we are looking at here, Leo, is the UK Policy Rate. It's set by the Bank of England, and has been very close to zero now for a number of years post financial crisis. That's the darker line which then edged down after Brexit.
But what's interesting is these dotted lines, which represent the market forecast of interest rates. And we've taken a snapshot of that forecast at different points in time, the first being in June of 2015, which is obviously well before the UK referendum on EU membership. Immediately pre Brexit is the grey, and then finally we've got one in January of 2017, which is the darkly dotted line.
Now effectively what we see here is that the market was pricing in, in June of 2015, a lift in interest rates, fairly gradual but getting up to around 2% by the end of this decade. Now post Brexit, with the uncertainty that the vote has brought up, interest rate expectations now are much lower. There is some pricing in of interest rate hikes, but over a very long period of time, and only getting to say 1% by 2020.
Leo Schulz: Now just before we get too involved in the more technical aspects of what's driving those changes in interest rate expectations, I'd just like to consider the fact that there's been a very strong rally, particularly in equity markets, in emerging markets, in the US. The S&P is up nearly 15% since the presidential election and UK equities have been very strong. I think it's an interesting combination of events that as interest rates are starting to go up, as expectations are going up, equity markets are taking off, there's this rally there. Paul, could you give us some insight into that phenomenon?
Paul Malloy (head of fixed income, Vanguard Europe): Yes sure, absolutely. So you're absolutely right that equity markets and risk assets have had a really great rally in the near term, but it's not an unprecedented rally, we've seen rallies like this occur in the past. We've also seen in this sort of time period, equities and risk assets sell off tremendously quickly. So it's a typical well-functioning market, driven by changing near-term events, so some of the positive events that we've seen this time is the Central Bank response post Brexit. The Bank of England pumped a tremendous amount of stimulus into the UK economy to attempt to front run the negative implications and economic forecasts of the UK referendum, so a lot of liquidity pumped in from the Bank of England.
Then you had the election of Donald Trump in the US, with an economic policy and a fiscal policy based around tax cuts, fiscal stimulus and infrastructure spend. And the market has really started to price in the positive effects of that sort of tax cut combined with that kind of infrastructure spend, as we have started to transition away from a monetary-policy-led economy to a fiscal-policy-led expansion.
Leo Schulz: Paul, to what extent in your view is the market getting ahead of itself? With regard to the infrastructure spending, we've heard some big numbers - a trillion dollars - but it's very much focused on the US - I don't think there's much chance of a significant fiscal expansion in the Eurozone. In the UK, the chancellor Philip Hammond has been very cautious about giving any promises about any additional spending that he's going to be doing. How real is the possibility of a fiscal expansion?
Paul Malloy: I think there are two different things to think about there: the tax side and the fiscal infrastructure spend side, and then if you think about it from a global standpoint, the implications on currency markets of such actions. So within the US, tax policy is something that's usually done very early in a new political administration and there's a history of tax cuts and changes in tax policy being an easier and lower hurdle to get over. So we think it's likely that there'll be some kind of tax reform.
Paul Malloy: Fiscal policy will take a little bit longer. A lot has been priced into the markets already, and so it remains to be seen whether the actual extent of these things coming through will have a much more limited upside than what's already been priced in. So markets are much more forward looking in that respect.
Leo Schulz: Alexis, what's your view on a fiscal expansion?
Alexis Gray: I think in Europe there's a lower likelihood of getting any sort of fiscal expansion. We had a little bit of extra spending from the UK government, which was to provide support to the economy right after the vote, but given that the economy so far doesn't seem to have slowed down, I think it's unlikely we get any more any time soon. We would need to see the economy deteriorate for the UK government to be willing to spend any more money because they're generally focused on trying to reduce their deficit at the moment.
And in the euro area there are quite a few countries with very high unemployment rates and very low growth, and unfortunately those are the countries with the most limited ability to spend additional money - they already have a lot of debt. The countries that can afford to spend more - their economies are in better shape and their taxpayers generally don't really want to vote for that and we have elections this year - so it's quite unlikely that we get fiscal policy out of the euro area either.
Leo Schulz: And is it the end of austerity in the UK?
Alexis Gray: I think there'll be a limited amount of austerity, there is an intention to reduce the deficit, so I don't think that's going away. But I would applaud the government in seeing that Brexit was an unusual scenario, so you have to have some wriggle room, you can't be too strict. If the economy is at risk of recession, you should spend additional money, at least in the short term, and I think they're open to that, they've already proved that.
Leo Schulz: Inflation is rising, and 1.8% was the latest reading in the UK, and also in the Eurozone, which is quite a jump in fact from the numbers that we're used to from that economic area. 2.5% was the latest number from the US. To what extent are those numbers reflecting the real economy and to what extent are they reflecting monetary conditions?
Alexis Gray: I think it's a combination of both. There have been a few unusual factors recently which have been driving up inflation. One is that globally oil prices have lifted, they were at very low levels in the start of 2016, and have since recovered. And oil is a component in a lot of things that we buy, even just for the simple fact that you need fuel to move goods around, so as oil has lifted, that's fed through into inflation.
In Britain the huge depreciation in sterling leading up to and after the Brexit vote has now made imports more expensive and that is the single biggest driver of inflation at the moment in the UK and is likely to push inflation up to 2.5%, if not 3% some time in 2018. But underlying that you have something a bit more permanent, which is that the labour market is quite healthy in the US, the UK, and in some pockets of the euro area like Germany. And so if you have more and more people working, earning money, they can afford to spend more, and so that's feeding through as well, but that won't be such a fast driver of inflation. It's more the oil and the currency story that have been the main drivers.
Leo Schulz: I'd like to come back to the employment market, but just before we do, I think over the past 13 or 14 months, oil's gone from about 28 dollars to around 60 dollars now, so quite a big increase there. Paul, Alexis gave us some good insights there in the UK, but what about in the US, what is the key driver there for inflation?
Paul Malloy: What you're really looking at is an economy moving towards full employment and fiscal stimulus and tax cuts coming at a time when the economy is really starting to really fire on all cylinders once again. I'm starting to see a creep up in wage inflation out of the US, and I'd say it's just much later in the economic cycle than I think Europe and the UK are.
Alexis Gray: Yes, and I think when you think about the balance of those two things, monetary policy has been more stimulative than fiscal. Fiscal policy has sort of been out of the picture, but if you start to add fiscal back in, you have less need to rely on loose monetary policy, so perhaps we get something more balanced, and actually more healthy.
Leo Schulz: Just on the employment market, there's a sense that the headline data is not necessarily giving us the kind of qualitative picture that we might have expected in the past and what I wonder is whether the quality of employment is not what it was – there is a kind of precariousness of a lot of jobs. And there are many jobs that don't come with any benefits, or that come on zero contract hours or there are situations where people are self employed even though they work for one organisation. To what extent is that a high level of employment? To what extent does the employment market really have leverage over employers, so that as prices go up, can it force wages up so that you get an embedded inflationary cycle?
Paul Malloy: I think in the US that's exactly what you're seeing; that was probably an okay argument to make a couple of years ago, the under employed as opposed to the unemployed. But now that you're seeing that start to move up in wage inflation and much of the slack removed out of labour markets in the United States, those are the conditions that are required for wage inflations to start to pick up.
Alexis Gray: Yeah, but the level at which unemployment generates inflation is probably lower, so we need unemployment to be even lower than where it was pre-financial crisis in order to start seeing wages pick up, for some of the reasons that you already mentioned: different types of contracts, more part time and more zero hour contracts. And so the Fed has been trying to guess at what point we'd start to see inflation and they've had to gradually lower their estimate. There's a similar sort of story in the UK: unemployment is below 5% but we're really not seeing wages rise very much. So we haven't seen that huge pickup in inflation that you would normally see at this level of unemployment.
Leo Schulz: When employment is growing, where wages are going up, where prospects are looking good, you'd expect a kind of feel good factor, but is that feel good factor there? It doesn't seem to be coming out politically.
Alexis Gray: No, I don't think so at the moment, well, look at some of the events of 2016. They suggest that there are a large number of people who aren't very happy; people voting to leave the European Union in the UK, people voting for Donald Trump who promises a very different type of leadership in the US, and even in the euro area, a sentiment of rising scepticism and people wanting some sort of change, whether it be leaving the euro or leaving the European Union as well. I think part of that is due to inequality, yes, the economy is growing in quite a few regions, but perhaps the benefits of a growing economy are being skewed to a smaller number of people who are at the top of the distribution and plenty of people are being left behind. It's quite clear that wages aren't growing for a lot of people in real terms and so that's why these sort of votes come out.
Paul Malloy: And I think that's an outcome of quantitative easing and the monetary policies post crisis, that you very much had a stock-markets-led rally, which disproportionately helps those with large investments as opposed to your paycheck to paycheck worker who relies more on wage growth to see a rise in their standard of living. You've seen that gap widen out, it's been widening out for many, many years now, other than just recently but we're starting to get to a tipping point.
Alexis Gray: And that's not to mention the impact of technology as well where technology has taken jobs away from quite a lot of people. More repetitive tasks can now be done with machines, and so another big reason why Trump was elected was a loss of manufacturing jobs in the US, and yes, maybe some of them have gone to poorer countries like China, but perhaps a lot of them have gone to machines, and so those people are also feeling left behind.
Leo Schulz: Monetary policy and QE tended to favour people who were the owners of assets, whether it was bonds or shares, or even property, as opposed to people who depended entirely on an income. As you mentioned earlier on, QE has been a significant factor in driving the rally in share prices, the major intervention of the Bank of England post Brexit vote. But how much fire power have the banks, the Central banks, still got left? What's their next move, what are they going to do now?
Paul Malloy: As far as fire power for another economic downturn, the US is starting to move off of zero interest rates, so that's starting to give them some traditional monetary policy tools back, but I think in the period post financial crisis, it's hard to say that they won't come up with some new and inventive ways to keep after their mandate. They still have that mandate and they can get creative, they've shown themselves to be more creative. Going forward there's no need to be creative as of this point in time, though what they're really trying to grapple with is how do they start to remove some of the stimulus and do it in such a way that's not disruptive.
So you're starting to see that out of the United States where they're maintaining the balance sheet for the near term and talking about 2018 being a point in time when they can start to reduce the balance sheet. The European Central Bank (ECB) cut down their purchase size beginning in March, I believe, from 80 to 60 billion, and so you're starting to see the ever so slight removal of that combinative policy whenever it began.
Leo Schulz: Alexis, in the UK, the Bank of England, did they overreact?
Alexis Gray: I don't think so, I mean I think given the situation that they faced, they came up with a very large stimulus about a month after the Brexit vote and at that time the economy looked like it was falling off a cliff. That's what they had in front of them and they had to make the best decision in the moment. Part of the reason the economy didn't fall of the cliff is because they did the stimulus, so we don't know what would have happened hypothetically if they had not stimulated.
Leo Schulz: How do you see them responding now to an economy that's growing at a greater rate than they anticipated and we're now seeing inflation edging up to their target 2%, what do you think the Bank of England are going to do?
Alexis Gray: I think they have a dilemma because as you mentioned the economy has not slowed down and inflation is now looking to overshoot target. They view the shock that came through the currency as being temporary so we get two to three years of additional inflation, but if the unemployment rate stays low, wage growth is picking up, then they may have to consider raising rates. I think though the counterbalance is that with the Brexit uncertainty, the economy probably will slow, we are already seeing that growth has become quite unbalanced.
I mean, part of the reason the economy is growing strongly is because you've had this drop in currency, foreigners have come in, they're spending a lot of money on retail, and we're seeing exports picking up. But it's somewhat imbalanced and I think as the reality of Brexit sets in, firms will probably hold back on investing and cut back on employment, which doesn't necessarily mean that we're heading for a recession in the next year or two, but that uncertainty may mean that we take some froth out of the economy.
Leo Schulz: So I'd just like to turn now to what your thoughts are on how bond investors should respond to current conditions. Just before we start this discussion I'd just like to look at a couple of slides, and we can come back and forth between the two if you'd like to refer to them. So this shows equities versus bonds in times of crisis between 2001 and 2016, so there have been some very real times of crisis in that period, and we can see that when there's a big fall in equities there will tend to be a rise in bonds, risk-free bonds we're talking about here, and obviously the longer the duration the greater the rise.
And just looking at the slide, and this is just showing the total return on the ten-year gilt, if the forward curve is realised, it's quite interesting that the total return remains positive on current projections. Paul, what are your thoughts about how bond investors should be dealing with the current scenario?
Paul Malloy: The equities versus bonds in times of crisis is probably one of my all time favourite charts. It really shows why you still need bonds; why bonds are such an important part of an asset allocation strategy. You need them there for times of trouble, and it's very, very hard to time markets or very hard to predict when the next recession is coming, so by the time you realise you need it, it's going to be too late. So you always need to have some allocation to fixed income and bonds in your portfolio for times like this, because what you're really after is your risk-adjusted performance: how can you get the highest return per level of volatility.
And as you start to look at fixed income as more of a staple in a portfolio, a broadly diversified portfolio, you really start to see the benefits that actually a yield rise could have in the longer term, that you're absolutely right as we look at the total return as yields rise, you do get a capital loss in the very short term. But if rates are going up that usually means economic growth is accelerating, so equities are going to be doing pretty well during that time.
So your overall portfolio is not going to be negative even if your bond position is short-term negative. But over the long time, now you start to reinvest those coupon payments, reinvest those maturities at these higher yields and you start to get a positive return out of these yields higher interest rates. So as long as your time horizon is longer than the overall duration of the fixed income investments, you end up in a positive territory. So it really goes to demonstrate that fixed income really does play a very important role in stabilising and in a well-diversified portfolio.
Leo Schulz: Alexis, what are your thoughts, what should a bond investor be thinking about now?
Alexis Gray: I mean, I actually think it's interesting, there's so much fear about yields rising and that hurting bond investors. But the bond investor over the long-term horizon is better off with yields rising than yields staying low. If yields stay low it means that coupon payments are very small and obviously we've had this dilemma since the financial crisis of where do I find yield if short term interests are so low and the rest of the curve is also low. So some lift in interest rates, particularly if it's because of a strengthening economy, is good news.
Leo Schulz: I'm guessing that people, pensioners for example, people who are living off the income of their investments, they're going to be better off and they're going to have more of that feel good factor that we were talking about.
Alexis Gray: Exactly, and I think one of the fears is how quickly this happens, so if interest rates were to pick up very quickly in a short period of time, that capital loss that we see on the charts could be deeper. But if we see sort of gradual lift, which is what we are seeing priced into the US markets, to a lesser extent in the UK now because of Brexit, if there's more time to adjust, then I think that capital loss is a little bit smaller and you can see that income component feeding in a little bit faster.
Paul Malloy: And if you look at long run economics and long run trend growth and demographics, it's more supportive of a gradual rise in interest rates as opposed to some sharp spike upward.
Leo Schulz: I've got to press you slightly Paul, what is a gradual rise in interest rates?
Paul Malloy: So you're looking at maybe the Fed in the US spiking twice per year as opposed to four times per year, you're probably looking at four times over the next two years at 25 basis points a piece, as opposed to yields moving up dramatically, or a steepening of the yield curve by central banks, by immediately not reinvesting in selling bonds off their balance sheets.
Leo Schulz: So that would take the Fed target rate to about 1.5% at the end of 2018, so that's still very low. It's a bit quicker than that, still a very low rate.
Alexis Gray: Not only is it important to understand what the pace might be of interest rate hikes, but where do we stop? And in all likelihood the peak of this interest rate cycle is quite a bit below previous cycles, so we're thinking maybe long term maybe 2.5% so that in itself will also pose a challenge for bond investors because we're not going to get back to the level of rates that we had before. Even when you take into account that inflation will be lower, in real terms we anticipate that the average return for a bond investor over the next decade, in inflation adjusted terms, is going to be lower than where it's been historically.
Paul Malloy: And that's going to flow into equity performance as well, you know the high flying returns of the 90s and over the post crisis stimulus period probably aren't going to be your returns over the next ten years either.
Leo Schulz: And just some summary points: improved growth and better economic conditions will push yield higher, and global uncertainty, among other factors, will moderate the scale and the pace of interest rises. Bonds of course remain core to a well-diversified investment portfolio and higher yields will benefit investors in the longer run. Anything to disagree with there?
Alexis Gray: Not at all, I'd just add one point though. I think that even though we have a more muted outlook for bonds and to a certain extent equities, I think it's going to be even more important for investors to focus on costs, so the amount of money you're paying to your asset manager matters more than before. It's a greater share of your overall return, so keeping fees as low as possible is crucial.
Leo Schulz: In a low-return world, costs become even more important than they have in the past, don't they?
If I could just remind listeners about the fixed income workshops, if you're interested, they will go through in some detail the courses of action that an investor, a bond investor might like to consider at the present time, both tactical responses and strategic responses. If you're interested, please do contact your Vanguard representative, or call 0800 9175508 or email email@example.com. And if you would like to follow our programme of webinars, we will be live at 2:00 March 21, when we will be focusing on political risk with Peter Westaway.
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