The global rate-cutting cycle is now underway, stirring up nostalgic memories of ultra-low interest rates that marked the post Global Financial Crisis (GFC) world.
Central bankers seem to have succeeded in bringing inflation down to more acceptable levels following the surge seen after the pandemic. High interest rates have crimped demand in the economy. The question that fixed income investors want answered is whether we are headed back to the “goldilocks’’ environment of the 2010s that sustained a 30-year relentless bull market.
To address that question, we need to analyse the differences between the macro setting that was prevalent then and the current environment. In the 2010s, markets had to bother about just the monetary policy, as government spending was austere. Globalisation and outsourcing to China meant that inflation was kept in check. Bonds were also supported by an unprecedented wave of quantitative easing.
Fiscal overhang
The world has changed a lot since then. Massive fiscal spending to underpin growth during the pandemic is one reason it took central bankers so long to contain runaway inflation. In our view, it’s highly unlikely government spending will disappear as political leaders try to keep their constituents happy.
Intense rivalry between the US and China has brought geopolitical risks to the fore, prompting many Western governments to boost investments in critical industries. Other factors too could continue to pressure inflation. Trade barriers have gone up. The backlash against immigration could boost labour costs.
Central bankers are now faced with the unviable task of steering the monetary policy while trying to second guess what governments might do. While the short-term rates are typically more reactive to monetary policy changes, the long-end rates reflect investors perception of inflation and growth.
UK 30-year bond
The chart above shows that 30-year gilt yields have plateaued near the levels seen before the GFC. This reflects the investors’ view that inflation is unlikely to soften to the benign levels seen before the pandemic, given the fiscal overhang. Although yield levels are elevated, bonds are not cheap if one looks at it from a longer-term perspective.
In the first quarter, there was an unexpected spurt in growth, which made markets to sharply tone down their expectations for interest rate cuts. Although central banks have started their rate-cutting cycle, it won’t be smooth sailing for them in the months ahead and they may have to scramble to counter the fiscal adventure and inflation volatility.
Hard landing unlikely
What explains the relative resilience of economies to high interest rates? In our view, the main distinction between the world that prevailed during GFC and now is the lack of leverage. The leverage of households as well as banks are now far lower than the GFC world. Bank capital ratios have improved tremendously over the past decade. Such low leverage and high levels of fiscal spending means it’s difficult to get a hard landing.
In the emerging economic and political landscape, it would be very easy to create inflation. We are entering a world where central banks will remain much more active. Monetary policy setters must be on top of their game to maintain a reasonable level of inflation relative to the economic activity.
While the search for a neutral level of interest rates that neither stimulates nor shrinks the economy is proving to be elusive, policy missteps may become frequent with central banks tightening or loosening their policies in reaction to boom and bust cycles. Interest rate volatility will become the order of the day along with inflation volatility.
As things stand, we are still long duration as we believe bond yields need to correct further given the slowdown in growth. The fall in yields will mostly happen in the front end of the curve and the rally may not be as big as some expect.
However, our confidence in duration trade has gone down and we favour curve steepeners. This environment calls for an active approach to duration management with exposure to a diversified pool of assets and the addition our Strategic Absolute Return Bond Strategy could help navigate the emerging volatile scenario better.
Investment risk:
While the Strategy aims to deliver above zero performance irrespective of market conditions, there can be no guarantee this aim will be achieved. Furthermore, the actual volatility of the Strategy may be above or below the expected range and may also exceed its maximum expected volatility. A capital loss of some or all of the amount invested may occur.
Emerging Markets risk: Less developed countries may face more political, economic or structural challenges than developed countries.
Credit risk: The issuer of a bond or a similar investment within the Strategy may not pay income or repay capital to the Strategy when due. Bonds which are rated below investment grade are considered to have a higher risk exposure with respect to meeting their payment obligations.
CoCos and other investments with loss absorbing features: The strategy may hold investments with loss-absorbing features, including up to 20% in contingent convertible bonds (CoCos). These investments may be subject to regulatory intervention and/or specific trigger events relating to regulatory capital levels falling to a pre-specified point. This is a different risk to traditional bonds and may result in their conversion to company shares, or a partial or total loss of value.
Bond connect risk: The rules of the Bond Connect scheme may not always permit the strategy to sell its assets and may cause the strategy to suffer losses on an investment.
Interest rate risk: Investments in bonds are affected by interest rates and inflation trends which may affect the value of the strategy.
Liquidity risk: Some investments may become hard to value or sell at a desired time and price. In extreme circumstances this may affect the strategy’s ability to meet redemption requests upon demand.
Derivative risk: The Investment Manager uses derivatives to generate returns and/or to reduce costs and the overall risk of the Strategy. Using derivatives can involve a higher level of risk. A small movement in the price of an underlying investment may result in a disproportionately large movement in the price of the derivative investment. Derivatives also involve counterparty risk where the institutions acting as counterparty to derivatives may not meet their contractual obligations.
Currency risk: The strategy can be exposed to different currencies. The value of your shares may rise and fall as a result of exchange rate movements.
ESG and sustainability: Investments are selected or excluded on both financial and non-financial criteria. The strategy’s performance may differ from the broader market or other strategies that not utilise ESG / Sustainability criteria when selecting investments.
ESG equity data: The strategy uses data from third-parties (which may include providers for research, reports, screenings and/or analysis such as index providers and consultants) and that information or data may be incomplete, in accurate or inconsistent.
The value of active minds: independent thinking
A key feature of Jupiter’s investment approach is that we eschew the adoption of a house view, instead preferring to allow our specialist fund managers to formulate their own opinions on their asset class. As a result, it should be noted that any views expressed – including on matters relating to environmental, social and governance considerations – are those of the author(s), and may differ from views held by other Jupiter investment professionals.
Important information
This document is intended for investment professionals and is not for the use or benefit of other persons. This document is for informational purposes only and is not investment advice. Market and exchange rate movements can cause the value of an investment to fall as well as rise, and you may get back less than originally invested. The views expressed are those of the individuals mentioned at the time of writing, are not necessarily those of Jupiter as a whole, and may be subject to change. This is particularly true during periods of rapidly changing market circumstances. Every effort is made to ensure the accuracy of the information, but no assurance or warranties are given. Holding examples are for illustrative purposes only and are not a recommendation to buy or sell. Issued in the UK by Jupiter Asset Management Limited (JAM), registered address: The Zig Zag Building, 70 Victoria Street, London, SW1E 6SQ is authorised and regulated by the Financial Conduct Authority. Issued in the EU by Jupiter Asset Management International S.A. (JAMI), registered address: 5, Rue Heienhaff, Senningerberg L-1736, Luxembourg which is authorised and regulated by the Commission de Surveillance du Secteur Financier. No part of this document may be reproduced in any manner without the prior permission of JAM/JAMI/JAM HK.