Since their inception, both the growth and income portfolios have adhered to a ‘Go high, go deep, go east’ investment strategy. A bias towards higher-yielding corporate bonds and equities, smaller companies and the Far East has served both well relative to their respective Apcims benchmarks. The recent sell-off in the bond markets suggests that government policy of ‘financial repression’ has entered a new phase – and investors should be positioned accordingly.
How did we get here?
Regular readers will be aware that I see this recession as different – it is a deleveraging and not a de-stocking one. It is built on excessive debt. There is no point in pursuing the traditional Keynesian policy of artificially boosting demand, as demand is not the issue and there is little money to fund it.
Both governments and consumers have spent too much, and the cupboard is now bare. Public spending in the West has reached unsustainable levels. Welfare benefits in particular have simply mushroomed, with little regard as to whether the state can afford future costs.
The answer is for governments to cut spending. But this is difficult for politicians to do in any meaningful way. For all the talk and pain of austerity, the coalition government has only been able to cut the deficit by a third. In other words, we are still adding to the debt – but at two-thirds the rate as previously. This is clearly unsustainable.
Cutting government spending and taxes would usher in faster economic growth, which is the best remedy. But we simply do not have the political will to do what is necessary. High debt levels, low growth, relatively high taxes and continued austerity – death by a thousand cuts – are all therefore here to stay in the West for a while.
So what are governments then to do? Default is the least desired option because of its economic and political consequences. Instead, they have decided to learn from history and pursue financial repression. This essentially involves keeping interest rates artificially low in order to stoke up a bit of inflation to help erode the debt.
This was, in effect, the policy pursued after the second world war when governments were faced with enormous debts. Initially it was successful. Debt levels fell relative to GDP. The problem with such a policy is that rising inflation can soon become uncontrolled inflation which then results in economic turmoil – witness the 1960s and 1970s.
This is a dark art which has a high casualty rate. However, for the moment, governments can be forgiven for believing the policy has worked. Spare economic capacity and banks not lending have been two reasons why inflation has risen but not yet caused alarm. Interest rates have remained relatively low at both ends of the yield curve, helped in large part by governments around the world printing money to buy their own bonds – Japan being the latest convert.
Part of the investment strategy has therefore been to ‘Go high’. Higher-yielding corporate bonds and equities have been the best way of navigating these tricky waters. In a low-growth environment, decent yield has rewarded, while the early stages of a pick-up in inflation should benefit both asset classes.
The next stage
So much for history. But this policy is now entering a new phase. The perception is that all markets fell in response to Bernanke’s comments on 22 May that the Fed may have to start reducing its bond purchases. After all, it makes sense – with the Fed not buying, prices should fall and yields rise.
But if one looks at the charts since the beginning of 2009, US government bond yields have tended to rise when QE is actually in operation, and then tail off when not. The facts substantiate this. At the start of QE3 in December last year, 10-year Treasuries were yielding nearly 1.7 per cent. Today they yield over 2.5 per cent. This is a big move for bond markets.
And such a move is logical. Printing money as though it’s going out of fashion is inflationary. The more money chasing goods, the more expensive these goods become. Modest inflation is, after all, the desired objective – there is a lot of debt to erode. And indeed, inflation has duly obliged – it has been quietly eating into the debt.
Yet inflation’s rise has been modest relative to the extent of money printing. This is in large part because the banks have not been lending – they have instead been repairing their balance sheets. Money supply growth has therefore been constrained, and in places it has actually been shrinking – especially in those Mediterranean countries where banks aggressively reduced their loan books. The opposing forces of a deflationary backdrop and money printing have, in very general terms, checked each other.
But the situation with the banks is now changing in the US. They are better capitalised and in better health. For two years now, lending has been growing. As a result, money supply is now subject to the normal rules. For the first time for a number of years, both government and bank policy is in inflationary mode. A corner has been turned. The bond market knows this, and is getting nervous. Prices are therefore falling, and yields are rising.
Talk of tapering QE is the symptom and not the cause. Some equity markets may be confusing the chicken and the egg, but bond markets know which came first. Bernanke knows the consequences of letting inflation roar – he is preparing the markets. Watch the bank lending figures as an early indicator as to the timing of the tapering. For now, the margin is OK – but it is narrowing.
Meanwhile, the UK and European banks are not in such good health as their US counterparts. But where the US bond market goes, others tend to follow. The gilt market may not have started its sustained bear run just yet, but the bull run is essentially over.
Portfolio changes
Investors need to be positioned accordingly. Within the income portfolio, I have therefore sold the only gilt holding, the iShares Gilt £ ETF (IGLT). Some of the proceeds have been used to top up the portfolio’s existing holdings in European Assets trust (EAT) and M&G High Income trust income shares (MGHi) – previous columns have highlighted their respective attractions.
Within the growth portfolio, I have also sold Aberdeen Asian Income trust (AAiF) and used some of the proceeds to add to the existing holding in Aberdeen Asian Smaller companies trust (AAS). This is a conscious decision to reduce my overweight bias to the Far East somewhat despite my positive view of the region in general. The introduction of Japanese exposure at the end of last year, and subsequent additions, suggests a modest rebalancing of exposure given regional political risks remain.
