The twin trends of ageing populations and technological innovation are likely to put a lid on inflation for some time to come, argues Newton fund manager Jon Day. But that doesn’t mean there aren’t opportunities out there for diligent investors.
Investors will need to learn to love low yields for some time to come. That was the message from Newton global bond portfolio manager Jon Day at a recent breakfast briefing, in which he noted how two long-term structural trends are helping to keep a lid on inflation.
On the one hand, ageing populations – particularly baby boomers in developed economies – are now not only spending less, but also de-risking their portfolios and moving away from equities in favour of bonds. For another, the internet, connectivity and the power of online shopping are creating better opportunities for consumer price discovery than ever before.
“It’s the Amazon effect,” he said. “It’s becoming more and more difficult for companies to raise their prices. I have friends in Australia, for instance, who now buy their suits in the UK and have them shipped to Australia because they know it’s cheaper to do that than to buy their suits at home. But it’s happening in every sector of every industry across the world. Taken together, these two trends – ageing and innovation in technology – are inherently deflationary. I wouldn’t say inflation is dead but it’s certainly struggling in the face of secular, long-term trends.”
Coupled with easy monetary policy and quantitative easing – whereby central banks provide an ever-present, ever-willing market for bonds – the overall effect has been for yields to practically diminish to zero and into negative territory in many cases, he said. “I know, for instance, that when I have a bond from my portfolio to sell, the central bank is there ready to buy at any price, day after day, week after week. Their mandate is to keep doing that until inflation comes back. But it’s not just the central banks: everyone is desperate for yield. There’s almost a default backstop for asset prices because of the scale of the demand. Right now, anything with yield just gets hoovered up.”
Unexpected consequences
The consequences of this low-yield backdrop are both positive and negative, according to Day. On the one hand, countries with reserve or quasi-reserve currencies are able to borrow for virtually nothing. In the UK, for example, the government’s decision to go ahead with its decision to build a high-speed rail network is boosted by its ability to issue debt at virtually zero cost. Japan has rolled over debt for decades at little cost – and without any real consequences. The US is running historically high deficits, yet yields remain at historic lows. Even Greece, hardly a watchword for fiscal responsibility, now has bonds trading at levels barely above zero.
Said Day: “In many ways, this supply of cheap money has become a de facto form of helicopter money. Governments are using the proceeds of their borrowing on infrastructure build, or on social programmes they know will be popular.”
The flipside of the coin
But cheap money also has its drawbacks, Day warned. It enables less-than-healthy entities to survive just by virtue of being able to roll over debt at practically no cost. In the corporate world, defaults become a rarity and the traditional risk/reward mechanism begins to break down, given the lack of penalties for fiscal profligacy. In consequence, active fund managers seeking price discovery find it ever more of a challenge to distinguish good companies from bad. Said Day: “In credit markets, it means there’s a whole raft of zombie companies out there essentially on life support. Part of our job as managers is to understand the cost of risk – but now that’s more of a challenge than ever.”
Current positioning
This doesn’t mean, however, that opportunities for fixed-income managers to make money are entirely absent. “The key thing is to find parts of the bond market where you’re being paid more than inflation,” said Day. “That’s why we think it’s so important for managers to be prepared to take an unconstrained approach.”
On the Global Dynamic Bond strategy, Day noted the portfolio was evenly balanced between sovereign and credit exposure with risk added to pockets of the market which have been weaker in recent weeks.
In sovereigns, the team remains underweight Europe and the UK, where yields remain in negative territory, but maintains an allocation to US, Australia and New Zealand.
In credits, the strategy is positioned to take advantage of the returns on offer from some of the more stable telecommunications and cable companies in the high-yield space. Day stressed, however, that this was based as much on quality and avoiding the prospect of defaults as on any sector view. “We’re almost absent triple Cs,” he said. “We won’t invest in companies we think are overleveraged or have overstretched themselves. We’re also avoiding commodities and the retail sector.”
In emerging markets, sovereign allocation is to local currency bonds in countries with the freedom to cut rates – or in hard currency in short-dated bonds in countries with cash reserves and the ability to refinance themselves should the US increase interest rates.
For the future, Day noted the coronavirus had transformed his outlook for 2020 from one he described as “a trundling year of steady yield, adequate risk and a reasonable return” to one where risks were now more prevalent. Even so, he said, investors were pricing in central-bank action in the event of serious economic consequences – hence the lack of any significant market volatility for now.
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