THE QE EFFECT
Mark Dowding, partner and co-head of investment grade debt at Bluebay points to the period of deflation, which concentrates wealth among the wealthy.
“Money ends up in the hands of the old and rich,” he says. “That is exacerbated by quantitative easing (QE), which has driven up asset prices by crushing the discount rate designed to counteract the lack of inflation.”
QE also drives down the cost of debt, which paved the way for many large companies to use cheap credit to finance share buybacks, which have been carried out on an unprecedented scale, particularly in the US. The move from equity to debt is another factor that concentrates the gains from economic activity in the hands of the wealthy few. But the political tide, at least, is now changing and politicians have woken up to the fact that fiscal, rather than monetary, policy needs to change in order to address the underlying causes of populism, but also to help re-inflate economies.
INFLATION AND THE BOND BUBBLE
Historically, when populist governments have taken over power, this has led to a period of inflation, driven by government spending on infrastructure and give-aways such as improvements in the minimum wage, which drives up consumption. In the US, this effect is most clearly seen with President Trump promising to cut taxes and spend on infrastructure, both of which will drive up inflation. But history also shows that populist governments tend to be led by inexperienced politicians – again, Trump is a case in point – who can find the barriers to reform are too high to overcome.
However, market expectations have clearly shifted in favour of higher inflation in the US in particular. Data from the Federal Reserve Bank of St. Louis shows the fiveyear forward inflation expectation rate jumped from 1.89% on 8 November 2016 to 2.06% two days later following the election result. By 13 January, it was up to 2.13% (a considerable distance from the 1.41% bottom it struck in June 2016).
BURSTING THE BOND BUBBLE
With rising inflation come rising yields and the potential for the end of the 30-year bull run in bonds (indeed some experts have already called the end).
Many investors would likely welcome higher yields, especially if it also meant a steepening of the yield curve. However, this won’t be a free lunch – as liabilities fall, so will the value of the bonds institutions are increasingly holding. The key question will be which side of the balance sheet falls further.
“Treasuries could break out of their threedecade bull run if yields on 10-year bonds got to 3% – 3.15% and stayed there for a sustained period – a few weeks,” says James Butterfill, head of research and investment strategy at ETF Securities. “In that instance, we could see a big change in sentiment towards bonds, which could be quite aggressive.”
One of the biggest challenges investors currently face is an over-allocation to fixed income as many have reached further down the yield curve to find returns while the duration of many mainstream bond benchmarks has moved out dramatically, making investors more sensitive to rate rises.
“In recent years bond volatility has been very low,” Butterfill says. “Many fund managers are holding more bonds than they would otherwise feel comfortable with. At the first true evidence of rising inflation, that comfort will likely turn to discomfort.”
There has been a good degree of myopic thinking around bonds with many investors believing the last three to five years have seen normal markets in fixed income.
“They have, in fact, been abnormal,” Bluebay’s Dowding says. “We could see interest rates return to 3%-4% in developed markets. We could be at the point of a regime shift. In the corrective phase we could see some ugly returns from traditional fixed income indexes.”
Duration in many bond benchmarks has reached around eight years, leaving investors more sensitive to rate rises at exactly the wrong moment. From a starting near-zero yield, a 1% move could mean losses in the order of 8%-9%, Dowding says.
