Fixed Income: Troubled Waters...
US Treasuries were the clear winners in the third quarter as investors rushed to safe haven assets. US Investment Grade Bonds are up 7.99% this year and US 30 year Bonds are up over 30%, year-to-date. There are two main reasons why US Treasuries did so well this quarter.
Firstly, ratings agency Standard & Poor’s downgraded the credit quality of US government bonds in August by one notch to AA+ after the US government struggled to raise the US debt ceiling. Even though the US debt ceiling has regularly been raised over the past 20 years, S&P did not like the political uncertainty that occurred prior to a bi-partisan agreement being made. Normally, when a country’s credit rating is cut, yields (or interest rates) in that country rise to compensate investors for the perceived higher risk. In practice, the inverse happened as investor flight to quality left them with nowhere else but US Treasuries to run to.
The second story of the quarter was the Fed re-introducing “Operation Twist” (as discussed in our currencies article), where they bought $400 billion of bonds with maturities of 6 to 30 years and sold bonds with maturities of less than 3 years. This is another form of monetary policy but, unlike Quantitative Easing (QE)(1), Operation Twist aims to manipulate long-term interest rates lower without printing more money and expanding the Fed’s balance sheet (hence avoiding inflationary pressures). Upon the announcement of this new tactic, risk aversion increased, yields fell and the US dollar strengthened. This policy was previously adopted in the 1960s where it was marginally effective but criticised for not being in place for longer.
Global Bonds - An Update
Emerging Market and high-yield debt also declined over the quarter as investors fled risky assets. All of our client model portfolios invest in an active global bond fund. The main reason we pursue an active approach (and not our usual passive approach) is because the major global bond market indices (such as the JPMorgan Global Government Bond index) are made up of bonds from the most indebted countries in the world who issue the most amount of debt (the US, Europe & Japan). We take the position that we do not wish to allocate our global fixed income exposure to the most highly-indebted countries in the world but, ideally, would prefer doing the opposite. To do this, we need to take an active approach and we thought it would be useful to provide insight into some of the conversations we have been having with our chosen global bond manager recently. Specifically, our conversations have centred on recent volatility and strength of the dollar.
During these times we do not want to lose sight of our core investment theses and have remained focused, despite this period of volatility. Below we summarise the main points of our conversation with the bond manager:
Causes of Recent Volatility
The dollar has strengthened against Asian currencies, the euro, Scandinavian and central European currencies. So, even though the value of these bonds in local currency has stayed relatively stable, US dollar investors would notice a fall in valuation when expressed in USD.
The long-term Asian currency thesis remains intact
Reasonably strong growth dynamics
- China, India and Indonesia as well as many others came through the financial crisis without ever going into recession. The resilience of those economies while going through these shocks illustrates strong fundamentals.
- The International Monetary Fund expects developing economies in Asia to grow at 8% or higher until 2016. If they are correct, this is a significant growth advantage over the rest of the world. They believe they should continue to draw in real capital flows in the form of foreign direct investment, anchored by the strength of China and of loose monetary and fiscal policies in the developed world.
- Although China has less policy flexibility than it did two years ago, it still has tremendous lee-way given its massive wealth of international reserves.
- Cushions against volatility in the region are even greater today than during the global financial crisis due to reserves.
Lack of leverage
- In some countries that did have more leverage, prudent regulation over the last three years has brought that down significantly. Many Asian economies are not highly leveraged.
- Low debt to GDP ratios in most of the Asian region provides policy flexibility to help counteract slowdowns as well as reduce the risk of some sort of debt crisis.
Good policy flexibility
- Most Asian economies have been proactive in raising interest rates. They believe the greater threat still in many parts of the emerging world is overheating as opposed to economic under-performance. If there is a growth shock, they think that they have the flexibility to be accommodative, given that they have been fairly proactive in raising interest rates.
Printing of money in Japan, the US and Europe
- As these massive economies continue to accommodate with what appears to be the most liberal and easy monetary policy on record, it is likely that capital is going to go globally. It will look for areas where there is less credit risk, where there is higher growth and where there is some interest-rate advantage.
- Once we get through the short-term panic, in which there has been a flight to US Treasuries, capital may well continue to flow back into Asian economies.
Access to credit in Asia
- The biggest shock to Asia during the global financial crisis was the seizing up of trade credit. In the current environment, the same is less likely to occur again because of the commitment of the Fed and the European Central Bank (ECB) to provide liquidity to the private sector, which should provide ample liquidity and credit globally.
- Although there might be some slowdown in Asian exports, there is unlikely to be a repeat of the complete seizing up of credit, which is probably the most important variable this time in Asia as opposed to during the global financial crisis.
Internationalisation of the Chinese remnimbi
- One of the key factors underpinning the long-term trajectory of Asian currencies is the internationalisation of the remnimbi.
- The process is motivated by the desire of China to move away from a US dollar-centric world. It will require greater flexibility on the nation’s capital account, which should allow for the currency to finally appreciate closer to fair value as opposed to the undervalued position it is in today.
The managers believe these factors should support Asian currencies over the medium to longer term, as opposed to just looking at the recent short-term panic, that led to currency levels in some countries similar to where they were during the financial crisis. To us, this could represent considerable long-term value and provide the ability to take advantage of what the managers believe to be temporary distortions.
Strong fundamentals in Scandinavia
- These countries have true AAA-rated credits.
- They are individual countries without the political complications and the indebtedness problems present in some parts of southern Europe.
- The weakness that they experienced during the global financial crisis was largely due to their very high concentration of loans to the Baltic region, but that crisis has been resolved, those loans have been recapitalised, and that part of the world has been growing again.
- They view them as having good macroeconomic conditions in terms of growth, current account surpluses and interest-rate advantages.
- When comparing Scandinavia to the rest of Europe, they believe there is far better longer-term value in Scandinavia.
Are we facing a global recession or are we in a significant soft patch?
- With regard to the US, it is important to look at the difference between companies not hiring people and companies aggressively firing people.
- In this post-financial crisis environment of deleveraging, companies have been hesitant to hire back a large labour force. As a result, we will likely see a persistently high unemployment rate, but that is very different from companies aggressively shedding labour.
The re-pricing of sovereign risk and currencies has been dramatic over the last quarter. The pace and range of the movement run counter to the notion of decoupling and prove that countries can be vulnerable to outflows of liquidity. As we see it, volatility in this asset class could provide us with long-term value and, through a disciplined and robust rebalancing process, we will aim to take advantage of these distortions for our portfolios.
- Traditional Quantitative Easing has led to a depreciating currency and appreciation of risk based assets
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