More Risk – Same Return
One of the intended consequences of the vast amounts of quantitative easing (QE) that have taken place in developed economies (I’ll avoid calling them ‘advanced’ as Mark Carney did yesterday as some are finding hard to move forward), is that bond yields have been crushed. QE has been generally supportive of asset prices from bonds to equities to housing but one of the specific elements of QE has been for central banks to buy vast quantities of government bonds and more recently, investment grade corporate bonds.  Only in Japan, perhaps the most ‘advanced’ in terms of QE has there been an explicit support of equities through the Bank of Japan’s purchases of exchange traded funds (ETFs) on Japanese equities. But the aforementioned massive central bank buying of bonds has left bonds offering little value.  Trillions of GBP of developed market bonds now trade at negative yields and in the UK at the time of writing ten year UK gilts yield 0.64% after the expected base rate cut earlier today and the extension to the Bank of England’s QE programme plus the initiation of a corporate bond buying programme.  Post-Brexit, the Bank’s Governor, Mark Carney and his Monetary Policy Committee (MPC) have wasted little time in trying to bolster a fragile economy.
But while the reduction in bond yields has rewarded bondholders as their prices have risen as yields fell, what of future returns? Leading US investment consultants, Callan Associates have highlighted the lofty expectations of investors returns and how they might continue to be achieved in the graph below.  Twenty years ago, bonds would dominate a low risk portfolio (as measure by the standard deviation of returns) and indeed ten years ago, bonds would be more than half of the required asset allocation even though the risk required had risen slightly.  Fast forward to the end of 2015 and bonds (they are even more expensive now) are in the minority with larger allocations to riskier assets required to gain the same annual return.  In fact, the risk required is almost triple that of twenty years ago and almost double that of ten years ago!
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What near zero or negative interest rates have done is to support asset prices yet they haven’t had the desired effect on economic growth which globally has remained lacklustre. A policy so focused on monetary policy is extremely unbalanced and has had its limitations exposed. Time for a change.
Those without many assets have not reaped the benefits of monetary policy and judging by recent political barometers, are feeling disenfranchised. Pursuing the extreme of restrictive fiscal policy and very loose monetary policy is not only too one-sided, it leads to…
The Brexit vote was possibly also a protest against the one-sided policy mix. One fiscal policy initiative in the UK has been to boost the minimum wage. While welcomed by many employees, the extra cost to employers has been given a mixed reaction.  The French have gone all out for increasing the minimum wage as shown in the following graph but as noted in the text at the top, French unemployment is still in double-digits while in the Netherlands it is a more respectable 7% and lower still in the US and UK (at the moment).
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The lack of labour reform in France has been a constant thorn in Franco-German relations. As well as an escalation in the minimum wage in France, it also has by far the highest union membership of leading economies as depicted in the following graph.  As many would-be holidaymakers to France would testify, French unions can be frustrating.  Perhaps when the French youth get a handle on the link between the high minimum wage, high union membership and high unemployment, they may realise that the older generation is hindering their job prospects.
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Over to you Chancellor
It is clear already that under the Theresa May Prime Ministership, the Osborne way of running the exchequer is a thing of the past. While we have to wait until November for the Autumn Statement from the new Chancellor of the Exchequer, Philip Hammond, a looser fiscal policy and a tool for a fairer society will most likely sit alongside the existing loose monetary policy.  A weak UK currency may persist for the rest of the year as a consequence but will also partly deal with our current account deficit.
Turning Japanese
Having criticised the Japanese for most of the past 20 years for their lopsided policy mix, are there any lessons to be learned from their recent stimulative policies. Having disappointed markets with their limited monetary policy response last week, the earlier in the week fiscal policy stimulant gained little attention. Admittedly, in terms of fresh new money for this fiscal year, it only amounted to JPY4.6 trillion out of an overall size of the economic package of JPY28.1 trillion.  Whether you think that is large or small, the impact on the Japanese Government bond market of that imminent change in policy emphasis was noteworthy as bond yields rose sharply.  In less than a month, yields on 30 year JGBs have risen from a handful of basis points to close 0.40% in yield as shown in the following graph. Quite a turnaround.
If Japan is leading the change in balance of monetary and fiscal policy, it could well be a pointer to what happens to bonds in other geographies for if yields can rise that sharply, prices fall especially in the longer maturities.
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Trump Card
November will not only see the UK’s fiscal response via the Autumn Statement but will also see the election of a new US President. The Donald has promised a massive spend if he wins and Clinton is likely to ‘trump’ that if she is elected to the White House.  Inevitably Europe will have to follow suit.  For now, bonds are trading like commodities, yields compressed by large-scale government buying but QE is close to if not at its limits.  When the imbalance is righted, it could be messy in bond markets but who knows when.  The first graph on asset allocation gives you a clue on the appeal of bonds in generating meaningful returns going forward.
Our Funds
While we have no private equity, we have little exposure to fixed income bond markets in our multi-asset Dynamic Fund as they offer little to the investor at these prices. We maintain an active non-sterling allocation of 30% in the Dynamic Fund.  Our Growth Fund being a global equity offering holds no bonds and is predominantly non-sterling by definition.
4th August 2016

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