16th December 2016
Having managed fixed income portfolios for well over a decade, the dangers of passive benchmark style investing are well known to us. Indeed, we would have shared our concerns with many of you over the years. As the evolution of any credit cycle will show, investor compensation for risk is gradually eroded over time. Declining yields prompt investors to extend duration and lower credit quality in order to generate similar levels of return. By the end of the cycle, investors are lending money for the longest time horizon in return for the lowest amount of interest. As active managers, Rubrics mitigate these pitfalls by focusing on those areas which offer the most reward for risk. From time to time this may require patience in waiting for the right entry yields. It is during times of volatility like those we are witnessing today that active managers, such as ourselves, can demonstrate both the ability to preserve capital and exploit opportunities that the market provides – namely higher future returns. Benchmark investors are constrained in how they allocate capital, and therefore are at a disadvantage in both preserving it during times of volatility and putting it to use when opportunities emerge. From Rubrics’ perspective, the volatility in November was a positive. If as we suspect, the road ahead is a rocky one, we will have plenty of opportunities to continue to build out return for our investors.
The global bond market felt the full force of the Trump effect with higher yields and a stronger dollar fuelled by market expectations of greater fiscal stimulus and higher inflation. In terms of the fixed income universe the Citigroup World Government Bond Index (on an unhedged basis) suffered one of its worst calendar month performances since 1996 declining by -4.64%. As we mentioned in our post-election update, whilst the bond market has moved to price in this eventuality almost immediately, the prospective benefits that may or may not accrue to the US economy of fiscal stimulus etc. will not be felt for years (if at all). The follow through to growth is far from certain, however the market psychology does appear to have shifted. With Draghi announcing a tapering of asset purchases in 2017 (as much out of a lack of securities to buy as out of expectation of future growth) he accompanied it with accommodative rhetoric regarding the potential for future expansion of the ECB balance sheet if necessary. Three months ago this may have been taken as dovish, not so today. In Japan, excessive yen weakness and the divergence between JGBs and US Treasuries may be creating a problem for the BoJ. With investors increasingly looking to sell JGBs in favour of the higher yields on offer in the US (and elsewhere) excessive pressure may continue to weigh on the currency. If inflation expectations begin to kick in Japan, raising the target on the 10-year JGB may be the next logical step and investors know this.
The market has certainly reacted to the recent increase in the Fed’s rate forecast. With more active fiscal policy in the offing, the Fed may be taking a harder line letting the economy ‘run hot’ as Janet Yellen indicated. Could there be conflict down the road between the Fed and the new Trump administration? The belly of the curve in the US reacted most aggressively and 5 year yields have hit levels not seen since 2011. The reaction of the long end is a little different, perhaps reflective of higher the dampening impact higher rates may have one growth in the longer term. We will watch this space with much interest. We have touched in the past on political risk becoming a bigger part our lives as market practitioners. Coupled with reduced central bank intervention, we would expect more bumps and bruises in the months ahead. Active management will be key in preserving and growing capital.
By Steven O’Hanlon