'The sound and fury'
Uncertainty has fanned demand for ‘safe haven’ bonds, which continue to attract long-term investors who want to diversify risk and to look beyond short-term market commotion.
The road to global economic recovery has been far from straightforward since the world recession of 2008/09, although for financial markets and most asset classes the journey for almost half a decade has been marked by strong gains and record returns. There have been surprises along the way, not least for the world of fixed-income assets over the last year. With global equity markets in recent weeks gripped by a bout of autumnal uncertainty, partly over the pace and shape of global economic growth, the perceived safety of less-risky assets such as gilts and Treasuries has attracted more nervous investors.
If you’d asked a habitué of the bond markets at the start of the year what direction fixed-income assets would go over the coming 12 months, the likely answer would have been one of lower prices and higher yields. Markets were confident that the economic recovery and the end of large-scale asset purchases – known as quantitative easing (QE) – in the US would presage a rise in near-zero interest rates – which would push long-term government bond yields up and prices down. The anomaly for bond investors in 2014 is that the opposite has occurred as demand grows for ‘safe haven’ assets.
The series of geopolitical risks that have shadowed 2014 – in particular the civil wars in the Middle East and Ukraine – have come to the fore this autumn, together with the threat of ebola and of a faltering eurozone. Consequently, volatility has increased for the first time in a while in financial markets. This confluence of disparate factors has also continued to push bond yields to their lowest level in half a millennium (European data goes back that far). Last week, the 10-year benchmark US Treasury bond yield dropped below 2% for the first time in 16 months. UK 10-yields edged below 2% and, in the eurozone, French and German bond yields fell further amid concerns over a slowdown for the German economy.
‘Struts and frets’
The anxiety over the pace of the global recovery is not new, and fretting over statistics from across the world’s markets is how markets behave. But the reaction of financial markets last week is difficult to square with the reality of the global economy – data may indicate a cooling but not a collapse. The fact remains that the US and UK economies are in recovery, and have enough steam for the props of loose monetary policy to be pulled away. Certainly, there is concern over Japan, but further stimulus could lift growth and asset prices too. The debate over China’s slowdown has continued this year, but its 7% growth rate is well ahead of any other large economy. Concern over faltering growth in the eurozone, including its German economic powerhouse, is not new; nor is the threat this could pose to the US and UK.
Moreover, each of the main geopolitical, economic and policy concerns for markets has been on the horizon at least since the summer; while the recent yield drop and price gains have extended what has been a year-long trajectory for government bonds. The wider paradox for financial markets is that the good news that the economic recovery is gathering momentum has allowed for an exit from QE, which has created uncertainty that equates to bad news for markets in the short term. And, in uncertain times, investors will rightly gravitate towards Treasuries, gilts and other government bonds.
There are a number of other factors weighing on the bond market. New regulations have made it more expensive for banks to hold back-up securities – known as ‘inventory’ – with the consequence that institutions have cut the size of their balance sheets; and a reduction of assets means there is less liquidity in the market and less capacity to step in to stabilise markets in the event of volatility. Jim Cielinski, head of fixed income at Threadneedle Investments, highlights poor liquidity – bond dealers are also not selling in the scale and quantity of yesteryear – as a challenge for markets, alongside the potential rise in interest rates.
Cielinski suggests that this environment could prompt investors to consider the more attractive returns from other parts of the fixed-income market, such as corporate bonds. Rightly, he points out that, although the market caution around interest rates is understandable, investors should remember that not all fixed-income assets respond in the same way. “While government bonds appear largely unattractive across most developed markets, corporate bonds still offer reasonable yield premiums,” says Cielinski. Corporate bonds have also enjoyed attractive credit fundamentals with moderate risk profiles and historically-low default rates. “The corporate bond sector offers a rich seam for right-sized, research-driven firms to uncover value,” says Cielinski.
Investors who want a long-term perspective on the volatility in recent weeks should remember that market disruptions often do not have a lasting effect – but they do provide investment opportunities. Fixed-income assets play a vital role in a well-diversified, long-term investment strategy, and investors who hold bonds alongside equities will be able to benefit from the different reaction that these have to market pressures. When sentiment starts to create short-term drama in markets, investors should remind themselves of the importance of a long view and diversification. The present may be full of sound and fury, but, from the vantage point of a decade or two ahead, perhaps, with returns accumulated in the intervening years, the market noise of yesteryear could well be just a memory.
The information contained above, does not constitute investment advice. It is not intended to state, indicate or imply that current or past results are indicative of future results or expectations. Full advice should be taken to evaluate risks, consequences and suitability of any prospective fund or investment. Where the opinions of third parties are offered, these may not necessarily reflect those of St. James's Place.