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What the managers expect: bonds, property and preservation

Fixed income, wealth preservation and property managers set out their expectations for 2017
December 15, 2016 & Kate Beioley

With 2017 rapidly approaching many investors are trying to predict the course of equity markets over the next year. But if you have a properly diversified portfolio, you will have exposure to a lot more than just equities. So we have asked a selection of high-profile managers of funds focused on other types of assets what they anticipate for the year ahead.

BONDS

John Pattullo, manager of Henderson Strategic Bond (GB0007502080)

“We had been living in a world of too much capacity and supply, with a lack of growth. Markets bought into the lower-for-longer secular stagnation thesis, so interest rates were lowered but consumers have not been borrowing. Meanwhile, governments have been using austerity to build up balance sheets.

“However, there has been a regime change in economic policy in the US. We have already seen bond yields sell off aggressively at the long end and equity markets have hit new highs. There has also been a massive rotation into financials and cyclicals away from safe bond-like stocks. That is a big reaction considering nothing has even happened yet.

“We are fairly sceptical that US President-elect Donald Trump’s fiscal policies will be effective and we are also suspicious about whether he will be able to push them through. I imagine the first dollar won’t get spent until autumn at the very earliest. ‘Trumponomics’ is a major change, but we do not think he will reset the growth agenda. We are also worried about his immigration policies, which would be deflationary, and his protectionist policies, making it tough to import things into America.

“The sense is that the equity market has leapt on this regime change under way, but our rather miserable view is that you might get half a per cent more growth and half a per cent more inflation over the next year. However, bonds hate inflation and growth, so for 2017 we like high-yield generally and have some time for investment-grade credit because spreads look okay on a relative basis.

“We are shorter duration than we were before this regime shift and have taken some interest rate risk out of our portfolio. The outlook for [US government] bonds is worse under Trump but in six months’ time, when no one wants to touch them with a bargepole, it could be time to buy them again.”

 

 

Rob Ford, portfolio manager, TwentyFour Asset Management

“There is so much uncertainty driving everything it is hard to predict where the 30-year Treasury long bond will be in a week’s time, let alone three months to a year. We are in the midst of a repositioning based on a fear of inflation, which is what is driving long bonds in the US.

“There is a brand new and different outlook, a different government and a whole new plan coming in the US, some of which will get executed and some of which won’t. There have been a lot of radical promises, but I think this will mean higher bond yields overall. However, yields will be volatile and trade within a wide range.

“The interesting thing will be rate rises. Europe is likely to have lower rates for longer so you might get less volatility there. In the US it’s more difficult because one should probably expect there to be a bit of a rally due to the various expansionist policies Trump might put in place. The question is, what does that do to inflation and bond yields? And that is more of a dilemma. We have absolutely no doubt that US central bank the Federal Reserve wants to see rates move higher, but they don’t want to do that while anything they do could potentially damage the economy and growth.

“I don’t think gilts are a buy trade for 2017, but if I had to be invested I would be buying them at shorter durations. There does still have to be a risk-off asset after all. I would be buying floating rate notes and asset-backed securities (ABS) – floating rate notes are defensive instruments in an uncertain rate environment.

“Investment-grade credit is still very expensive in Europe, driven by quantitative easing (QE) and in 2017 those assets will remain very much driven by central bank buying while liquidity will remain an issue. European Central Bank (ECB) president Mario Draghi and Bank of England governor Mark Carney are not about to wind down those programmes in a hurry, so those drivers are likely to remain in place for corporate bonds.

“Long-duration government bonds are very unloved and you could make a lot of money with these – but you could also get very hurt. It is a knife edge. You could make 10 points backing 30-year Treasuries in a heartbeat or lose 15.”

 

Ariel Bezalel, manager of Jupiter Strategic Bond Fund (GB00B544HM32)

“While the world remains hampered by enduring economic imbalances, the evidence suggests that inflation in developed economies is indeed starting to pick up. Market indicators, such as break-even inflation rates, are rising in the UK, US and Germany, putting upward pressure on government bond yields. In China, economic growth is ticking along nicely, a reflationary force that is reflected in resilient commodity prices, brighter US service sector data and wages, and in Europe where the reflationary policies of the ECB are starting to bear fruit.

“The outcome of the US presidential election has been taken by the market as a further inflationary signal. Donald Trump has been particularly vocal on the need to boost fiscal spending, a measure he said he would fund via debt issuance. A meaningful debt-funded infrastructure programme could help to stimulate the economy and be quite inflationary.

“Inflation risk was one of the main drivers of our recent decision to cut portfolio duration. Reducing duration risk by more than half has enabled our portfolios to weather the recent upward pressure on bond yields. Nevertheless, the US Treasury bond market has backed up significantly since the US election and there is a risk of further instability in the year ahead. A tightening of Federal Reserve policy, albeit gradual, is not a particularly conducive backdrop for the sort of aggressive fiscal stimulus expected under Donald Trump.

“Paradoxically, the president-elect will be relying on the respective asset purchasing programmes of the ECB and Bank of Japan (BoJ) to help keep a lid on yields, sending investors towards the US Treasury bond market to pick up yield at a time when the administration is seeking to raise funds for infrastructure programmes. While this may help in the short term, it creates a fragile dynamic in bond markets, which could easily change if either the ECB or BoJ alter their policies for domestic reasons, or inflation really does start to surprise to the upside. The upward pressure on the dollar must also be watched closely, given the risk it poses to emerging markets with large dollar obligations.

“In credit, our focus is on short-dated paper with decent carry alongside ‘special situations’ where we see the possibility of significant capital gains.

“We are also allocating to emerging markets such as India and Argentina, two countries where the economic and political backdrop looks favourable and where we believe it is possible to capture attractive yields without compromising on credit quality.”

 

WEALTH PRESERVATION

Talib Sheikh, manager of JPM Global Macro Opportunities Fund (GB00B4WKYF80)

“Our portfolio is tilted towards a lower than expected global growth and inflation outcome. Global growth was better than we expected through the third quarter, and despite some volatile data we have seen healthy labour market and consumption data in the US.

“However, three key areas cause us to remain concerned about global growth. In China, the authorities have signalled plans to curtail the stimulus that has helped to drive growth and this should weigh on the property market, and subsequently growth. There has been no evidence yet of a material impact on the UK or eurozone from the Brexit vote, and we would expect some form of slowdown to materialise as a result. Trump, while potentially increasing fiscal spending, increases uncertainty and is more negative for growth outside of the US due to increased protectionism and concerns about trade.

“On an aggregate basis we are long the US dollar, which should also benefit in a risk-off environment as well as the Federal Reserve moving increasingly towards an interest rate hike over the coming months. Low inflation has persisted across much of the globe; however, we expect inflation in the US to continue normalising and elsewhere rates to start stabilising. Our core view of a low-inflation environment across many developed economies and even emerging markets economies, persists. While we have seen cyclical assets continue their outperformance of recent months, we believe this is driven by higher inflation due to commodity price increases and base effects, rather than a growth-led pick-up in inflation.

“As such, our equity market composition is focused on short exposure in growth-oriented sectors such as energy and industrials, and long exposure in defensive areas such as healthcare and telecommunications. Within defensives we are focused on high-quality names with broadly strong dividend earnings potential, which should benefit in an environment of continued low inflation. Companies in the defensive sectors offer decent dividends that are high in quality as they are typically backed by strong cash flows, making them attractive in a low-inflation environment.

“We are concentrating on the relative value exposure of the portfolio rather than taking directional risk. We continue to have high conviction in the defensive sectors because we expect lower than expected nominal gross domestic product (GDP) growth, and as such have a preference for companies whose earnings prospects are not necessarily a function of cyclical uplift in global or economic growth.

“We expect demand and supply dynamics to maintain downward pressure on the oil price, in part driven by a slowdown in China. While oil companies have already cut capital expenditure to protect their balance sheets, we would expect dividend cuts to come next, which would be negative for the sector.

“In fixed income, we have become more nervous about duration and reduced the interest rate sensitivity in the portfolio to just over a year. We favour exposure in the US, in line with our view that the Federal Reserve will raise rates in the near term.

“We continue to hold long US dollar exposure versus short emerging markets and commodity-exposed currencies, as US growth is likely to remain above trend and long US dollar exposure has the potential to add value in a scenario where market pricing of the pace of US policy normalisation increases. The US dollar could also strengthen if a risk-off environment prevails, which may unfold as policy uncertainty rises, and if Trump is negative for growth outside the US due to increased protectionism and concerns about trade.

“Before the vote for Brexit there were already increasingly erratic correlations between stocks and bonds, as price action in asset classes has been distorted by central bank policies. At the same time, the Sharpe ratio of holding a mix of assets – ie, the amount of return investors receive in exchange for the risk they tolerate – has dropped dramatically. This means the investment case for traditional balanced investing has deteriorated.

“A practical example can be found in the increasingly unreliable correlation between asset classes. At various points, the conventionally and dependably negative stock/bond correlation has confounded historical norms and turned positive.

“In essence, investors can’t trust asset classes to behave. This undermines the notion that a simple long-only, stock/bond balanced portfolio still constitutes true diversification, and underscores the need for investors to reassess where their diversification is coming from and the stability of that source.

“The ageing six-year US bull market has investors wondering if a sizeable correction is near. When stocks look fully priced and bonds remain extraordinarily expensive, alternatives offering a differentiated return stream hold appeal.

“Relying on long-only beta to deliver returns may not be enough. It will become increasingly necessary to tap into a mix of sophisticated strategies such as relative value, derivatives and dynamic hedging strategies – to diversify away from less attractive traditional asset classes and to deliver positive returns across both up and down markets.

“Finding positive returns from diversified sources starts with tapping into macro trends driving global capital markets. These can give rise to specific thematic investment ideas, either through more traditional market beta-linked returns, such as long positions in equities and bonds, or more sophisticated strategies that are not reliant on the direction of the markets to generate returns.”

 

 

James Clunie, manager of Jupiter Absolute Return (GB00B6Q84T67)

“Events that appeared unlikely at the start of 2016 – a vote for Brexit and the election of Donald Trump as US president – have come to pass.

“While these events might have been deemed unlikely, they were far from impossible given the narrow range of possible outcomes involved in each. However, as the credit crisis reminded us, it is not just the probability of the event that we need to worry about, but the damage (or pay-off) involved when it occurs. But nobody can say with any certainty how the current uncertainties might be resolved. Markets seem pretty convinced that significant infrastructure spending is on the way in the US. The general prognosis seems to be that Trump’s election is good for equities and bad for bonds, although it appears unlikely that both can be right for a prolonged period, especially as valuations in US equities are already at an extreme.

“Students of financial market history will find many episodes where our models for forecasting the future have proved deficient in the face of seemingly random events. There are a number of well-known behavioural biases such as recency illusion, confirmation bias, the Gambler’s fallacy and the focusing effect that can colour our assumptions and the sorts of decisions we make based on these models. While Brexit and the US presidential election have created respective uncertainties, people are now expecting the unexpected in ways they perhaps weren’t a year ago. Time will tell whether these fears are indeed justified – and volatility does in fact pick up – or whether we are witnessing a further example of our behavioural biases at work.

“Given the challenges we all face in dealing with an uncertain future, preparing for change is an important part of our investment process. This includes being vigilant about the structural integrity of the long/short book and how the equity exposures might hold up in certain scenarios. We also seek to use imperfect hedges, where appropriate, and to include positions in assets that have a quality of ‘anti-fragility’ – ie that thrive on volatility.”

 

COMMERCIAL PROPERTY

Richard Kirby, manager of F&C Commercial Property Trust (FCPT)

“The market is more stable now than immediately after the vote for Brexit: investment volumes are down but transactions are happening. Pricing is about 3 per cent off what it was around 23 June, but there is a lot of equity looking for real estate. Although some open-ended funds had to sell property after the referendum, in the main they managed to do it.

“Property is being traded and open-ended funds are buying again. Overseas investors, especially from the far east, are looking at areas such as central London and opportunistic money is looking to be deployed. It is still a very competitive market.

“We expect total returns of around 2.6 per cent to 2.7 per cent for 2017, while for 2016 it should be marginally positive – about 0.5 per cent. Five-year total returns should be around 5 per cent and, as that will largely come from income, commercial property investors will need robust, resilient and sustainable property.

“In terms of our investment activity we are being opportunity-led. Retail warehousing pricing has moved out, so could offer some opportunities. We like local hotspots in areas such as technology and infrastructure improvement, and we look to buy core plus property that’s well let and in sustainable and permanently growing locations.

“Certain sub-sectors should do well. We are keen on urban industrial property and logistics – these will continue to outperform due to structural changes in the retailing market, with low voids and rental growth in this sector.

“Certain office locations based on technology should do well, as well as properties that benefit from infrastructure changes based on the devolution of power.

“Leisure is outperforming, for example food and beverage outlets in nice established locations people want to visit.

“Prices are holding up but we are taking a risk-averse stance. At the beginning of the year we were looking at more development, but post-Brexit vote we are in a more defensive mode, so are considering developments on a very selective basis. We want sustainability and protection of income – a more risk-off approach. We will look to well-let assets with relatively long leases and the protection of the income stream, where we can asset manage to add value.

“The main risks to UK commercial property include uncertainty around Brexit, and rising bond yields as many investors look at the risk-free rate of property above a gilt yield – and rising interest rates push up the risk-free rate so property pricing might adjust. But real estate still provides an attractive income stream.

“Retail and city offices face challenges – especially City of London offices – so we have low exposure to this and wouldn’t increase it.

“We are being careful about certain segments: longer leases on good covenants with a fixed uplift within the lease, possibly linked to retail prices index inflation are looking expensive. And some properties in alternative areas and food stores are fairly aggressively priced.

“There is not a big development boom so not a big supply of these coming to market. We’re letting properties at a higher rent than pre-Brexit. Rental growth will be subdued, but there will be local hotspots. Older offices being converted to residential property is also having quite an impact.”