Mid Monthly Update – June 2019
The Cricket World Cup is currently taking place in England and Wales, and there are a few games taking place at Trent Bridge here in Nottingham. I was fortunate enough to be at the England vs Pakistan match last week. A cracking match but England lost. England almost had their captain suspended for a slow over rate. However, this update isn’t about cricket although as I write this, India are due to play New Zealand if the rain lets up. Non-cricket fans can breathe a sigh of relief. This update is about the recent collapse in bond yields in developed markets.
A year ago, markets were pondering how many rate hikes there would be in the US in the ensuing 12-18 months. One more quarter point rise followed the June hike in 2018 then after expecting two more of a similar size this year, the Fed changed tack at the beginning of 2019. Now the debate is how many rate cuts will we see over the next 18 months? The large tax cut that Trump brokered and bolstered US growth last year has ebbed and data now points to slowing economic growth. From excessive growth requiring a monetary handbrake, markets now see a recession looming and a significant easing of monetary policy. This oscillation in temperament has seen ten year bond yields plummet from 3.25% last November to 2.11% today as seen below in the chart from Investing.com The ten year and one year bonds now yield the same so you’re not being rewarded for taking a lot more interest rate risk.
In the UK, the Bank of England is considering an increase of 0.25% from 0.75% to 1% at its next Monetary Policy Committee meeting next week on 20 June; the day after the US Federal Reserve meets to discuss US monetary policy. Earlier this week Deputy Governor, Ben
Broadbent told a parliamentary committee that the UK economy warranted higher interest rates. What concerns the Bank is that wages are running at a 3.4% annual rate while unemployment is at a 44 year low at 3.8%, basically full employment despite what you see in the media. Effectively, you can get a job if you want one although it might not be the one you want or where you want it. Inflation, as currently measured by the Consumer Price Index (CPI), is running at a 2.1% annual clip, just above the Bank’s inflation target.
So with UK base rates at 0.75%, possibly going to 1%, National Savings offering 1% for instant access accounts, why are ten year maturity UK government bonds (gilts) currently yielding 0.83% from double that level last September as depicted in the chart below? Do investors want to take on interest rate (duration) risk at a lower yield for the same credit? The rationale might be that those investors foresee an economic environment whereby they can sell those bonds to someone else at a lower yield/higher price in the future. But owning an asset that is over 1% below inflation is tough to justify. The T. Bailey Dynamic Fund seeks an outcome of 3% over UK inflation so we would need to take on some scary credit risk to achieve our target outcome. We don’t and haven’t for some time nor do we see the value in taking on excessive credit risk to attain a preferable yield.
As stewards of investors’ savings, our role is to aim to maintain investors’ wealth in real terms (above inflation). Whereas in the US, inflation expectations have fallen, they have been on the rise in the UK.
Bonds have become like commodities, driven by supply and demand above their normal yardstick of providing a positive return above inflation – unless you completely disagree with the Bank of England and believe that economic armageddon awaits, possibly on the back of no-deal Brexit. Venture into Europe and it’s hard to acquire a positive yield, with ten year German government bonds yielding negative 0.25%.
In short, owning bonds is overrated at this time.
Irresponsible Rating Knowledge
I rarely get irked but in a couple of weeks when Neil Woodford has rarely been out of the headlines, the fall-out has rightly shone the spotlight on those that benefit from a form of box-ticking that drives asset flows. The ensuing endorsement or rating is supposed to give the individual investor and or their financial adviser some comfort that appropriate due diligence has taken place.
However, it would appear that some raters have been asleep at the wheel and reacted after the event by downgrading Woodford’s fund(s). The Treasury Select Committee, which oversees the industry regulator – the FCA, has asked what some of the rating intermediaries make from having high-profile brands on their recommended lists. The inference here is that it is easier to have brands on the list in order to accumulate assets. That is not necessarily to the benefit of advisers or their clients.
As fund providers, we pay a license fee to use rating providers as ratings, typically risk-based, are there to help advisers and their clients choose the appropriate fund solution. It is a sort of pay to play arrangement. For many rating firms, we are too small to bother with but not all. We don’t always pay the entry fee if we feel the necessary due diligence is absent and will not be in the investor’s interest.
As fund of funds managers, we are seen by many to be out of fashion yet our approach which seeks to deliver meaningful outcomes net of fees, is a diversified approach, validated by a third party quantitative research group to ensure each of our holdings is additive on a risk-adjusted basis. Consequently, we are more diversified than many of our peers but this also aids liquidity – a subject suddenly in focus but not a problem for our investors.
As we noted in our recent blog ‘A Misalignment of Interest’ (contact us if you haven’t received it by email), we haven’t held any Woodford open-ended funds since he started his own firm.
It’s Just not Cricket
Unfortunately the India vs New Zealand match was abandoned with no overs bowled.
Apologies for the unusually long update this month, this isn’t the start of a trend. We have made no changes to either fund so far in June.
Thank you for your continued support. It is greatly appreciated.