Transcript: Fixed income investing in uncertain times

So let’s turn to the first slide, little bit of history on Chris. Chris will be familiar to many of you as the author of Iggo’s Insight, which is a regular economic commentary, which summarises his views and our views of the environment we’re currently in, and Chris originally joined AXA Investment Managers as an economist and graduated to become Chief Investment Officer in September 2008. That was a pretty significant year for our Fixed Income team. In March of that year we were adjoined by Theo Zemek. Theo joined us with a brief of revitalising and reenergising our Fixed Income team.

And if we turn to the next slide, you’ll see the sort of the basic structure of part of that team that reports through Chris. Theo as I mentioned is Global Head of Fixed Income, Chris, Chief Investment Officer, and you can see a number of areas that fall within his remit. And one of the things I think that’s important about our Fixed Income team and something that we emphasise very strongly is the team nature of it. The way that the team all work together is something that Theo has driven and Chris has executed as a totally collegiate approach.

So of course, you know, it’s relevant to equity markets as well as fixed income markets, Chris, but everything seems to be dominated by the economy, what’s going on in Europe and around the world. Perhaps you’d like to set us the scene and on the first slide looking at the Purchasing Managers Index, but give us a summary of where you think the economy is globally and what are the key drivers?

Chris: Well, I think overall the economic outlook is still quite soft. I mean even the US economy, which seems to have quite a bit of momentum at the moment, is probably only going to grow by about 2½% this year, and that compares reasonably unfavourably with the historical average, which’ll be closer to 3 or 3½%. In Europe, it looks as though some countries in Europe will be in a recession. The UK economy is flatlining; Japan’s not doing much better. So of the developed economies it’s a kind of low growth environment that we’ve been living with for a number of years now and probably will continue to live with.

So that’s the broader context, but at the moment there do seem to be some more positive signs. If you think back to last year there was a slowdown in economic growth. You can see from the chart these Purchasing Manager Indices which are a very good broad indicator of overall economic conditions. They focus on the manufacturing sector, but they give a good signal as to what’s going on in the entire economy. They dipped in the second half of last year. If you recall what happened we had the Japanese earthquake, that disrupted global manufacturing, and then we had the European debt crisis, which caused obviously a big hit to confidence both in the financial markets but also in the real economy.

Since around about November the data’s been quite a bit stronger, so we’re seeing the US starting to perk up, the UK doing a little bit better. Europe’s more mixed, but even Germany is now looking quite good.

Presenter: And the horizontal black line is essentially neutral?

Chris: Yeah, the 50 on the chart is basically a neutral level. So if the line’s above 50 it means the economy’s growing; if it’s below 50 it means we’re in recession.

Presenter: And so looking at this Europe is still very much continuing to lag behind everything else, and is that just driven by the macro sentiment or is there any sort of key drivers?

Chris: No, I think there’s some real impacts on Europe. First of all you’ve got in a number of countries fiscal tightening, so governments are cutting spending, raising taxes in order to deal with the debt problem, so that’s a big drag on economic growth. Secondly, you’ve got a credit crunch, because the European banking system is under pressure to reduce the balance sheets and to deleverage, that’s having an impact on economic growth as well.

Presenter: Okay, so let’s move onto the next slide which is focussed more on inflation. You know, CPI seems to be improving. You’re looking at this chart here we’re seeing a sharp downtick in the UK in particular, but also a downward movement in the US and Europe as you sort of mentioned earlier is still sort of bobbling along there. What are your thoughts on this, on the threats of inflation?

Chris: Well the short term threat to inflation is coming from oil prices. So what we’ve seen over the last two to three years is quite a lot of volatility in oil prices, and that feeds through quite quickly into consumer price inflation, because petrol and other energy products are an important part of the overall consumer basket. So I think we may be going through a little bit of a dip at the moment, which is to do with, you know, comparisons with last year. But given what’s happening to oil prices, given the tensions in the Middle East, that could quite easily reverse again and we could see an upturn in inflation in the second half of the year.

Thinking further ahead, I kind of think two conflicting forces. One is that economic growth is fairly soft and there’s a lot of spare capacity in the major economies. Now many economists would say that’s a recipe for deflation rather than inflation. But the other point is that what central banks are doing, central banks are rapidly increasing their balance sheets, printing money through QE and other unconventional monetary policies, and there is a school of thought that this will lead to inflation, you know, further down the line. So our view is that inflation may remain low for the next year or so, but there is a risk of it being higher somewhat over the medium term.

Presenter: Okay, I guess looking at this slide here we’ve seen some pretty extreme movements in the US inflation data there, how much of that is reality and how much of it’s just the way the numbers come out?

Chris: Well as I said before a lot of it’s determined by what happens with energy prices. So in the US gasoline is such an important component of the overall headline price index. So we get these big moves in oil prices, it has a fairly quick impact on inflation.

Presenter: Okay, so let’s move that out then and look at interest rate expectations as a result of that. We’ve got a graph here showing the three month interest rates, and looking at that, you know, there’s sort of an upward trend and yet we’re hearing constantly from central bankers and Bernanke was saying only the other day about the fact that interest rates are going to stay low for the foreseeable future.

Chris: Yeah, well if you look at the scale on the chart you can see that the market still expect rates to remain very low. This is just taking the current market expectations of where short term interest rates will be over the next couple of years. And even by the end of 2014 we haven’t really got much of an increase in rates from where we are today. And, you know, I think that the economic environment being quite soft, inflation being relatively under control in the short term, and central banks are saying we need to keep monetary policy very easy, very accommodative, so interest rates at current levels for at least another year, possibly two more years, and all this unconventional policy like QE remaining in place.

So if you take this and you take what the central banks are saying you think we don’t have to worry about interest rates going up for quite a long time. So for the bond market that’s usually a positive indicator. The question is whether we believe that and whether we think in reality interest rates can remain that low for such a long period of time. I tend to think now that by the time we get into 2013 markets will have started to challenge this view and market forward looking interest rates may be somewhat higher.

Presenter: Okay, well let’s move onto Europe now and on the next slide have a look at the spreads versus Germany, I mean what’s your fundamental view on Europe? Clearly the news flow has diminished somewhat over the last couple of weeks, but, you know, have we reached the stage where people actually believe there is a solution here or is it just that it’s kind of been put behind them for a couple of weeks so they can focus on something else?

Chris: Well as the Americans say the can’s been kicked down the road quite a long way. The underlying problems are still there, there’s no getting away from that fact, and the underlying problems are that these countries have got too much debt. The governments have too much debt, and they tend to be running quite large annual budget deficits. So the long term solution is to cut spending and reduce debt. Now that’s not easy, because that means you have these big austerity programmes, we’ve seen the backlash politically in places like Greece economies are in recession.

So where are we today? I think three things that have happened have improved market sentiment. First of all the fiscal compact that was agreed between all the European leaders, apart from the UK of course, back in November. We’ve had the ECB providing almost a trillion euro of liquidity to the financial markets and we’ve had the Greek debt restructuring. All of those three things have combined to significantly reduce the risk that the euro would fall apart, and that was a genuine risk, you know, six months ago. That’s kind of disappeared for the time being. It means that countries like Italy and Spain, which are too big to be bailed out in the same way that Greece, Portugal and Ireland have been bailed out, have got time to put in place reforms, to reduce their deficit, to reduce their borrowing.

The chart shows what’s happened to spreads, and if you take the example of Italy, in the last 20 years Italian spreads over Germany, so the difference between Italian government bond yields and German government bond yields have been as low as zero and as high as 6%. The fundamental value is somewhere in between, we don’t know quite where. It’s probably a little bit lower than where we are today, and I think over the next few months we’ll see a steady improvement in the pricing of the peripheral European debt markets.

Presenter: And yeah I mean you see quite clearly there looking at the Italian curve there you’ve seen a sharp improvement on that over the last couple well I guess couple of months on this scale. Has that been true across all of the sort of non-German Eurozone countries?

Chris: Yes, it has, with the exception of Greece obviously which is a different kettle of fish, and also Portugal. Portugal’s been somewhat disappointing, because there’s a feeling in the markets that Portugal will be the next Greece, and now I don’t think it’s quite as bad as Greece, but Portugal’s a small economy with very little growth, and it’s going to be difficult for Portugal to deal with its debt problems.

Presenter: And I guess if you look at the fundamental issues with the austerity programmes is that people will tolerate them for a short amount of time, but if they don’t start to see some benefits coming through then all of a sudden it all becomes a fractious issue again.

Chris: Absolutely and the real risk is political now in Europe, because you’ve got a number of elections coming up. There’s elections in France next month, elections in Greece. In Italy, we have a technocratic government, which is in place for probably another year, trying to implement pretty far reaching reforms but without a popular mandate, so there is the scope that you’ll get further public backlashes against these austerity measures. So I think Europe remains quite volatile, it looks okay at the moment, but there is that risk that things could blow up again.

Presenter: Okay, let’s move onto the actual fixed income strategy and have a look at the three key areas that you think are relevant to the fixed income market.

Chris: Well we’ve talked a bit about interest rates already, about how the market is priced such that interest rates will remain low for another two years. That may well be the case, nobody really can see the future that clearly, but to us it means that core government bond yields the kind of yields on UK gilts or German bunds or US treasuries are very, very low and very, very unattractive from an investment point of view. You’re talking about 2 to 2½% yields for ten year bonds, which we think is overvalued.

They’re at those levels because last year they were assets that were favoured during the crisis, so there was a lot of safe haven money flying into these markets, 2½% yield is well below the long term average and it’s well below what you’d expect from nominal GDP growth for example which is a kind of key metric for valuing these things. So the risk to us is that we will get some upward shift in forward looking interest rates. So that means the yield curves would steepen and government bond yields would increase. So it tends to suggest a short duration type of investment strategies.

Presenter: And looking at the catalysts for the long end of the curve to rise I mean there’s clearly a huge demand out there for long-dated government stocks from pension funds, that’s not going to go away. So, you know, other than a shock in Europe what are the other big risks you see?

Chris: I think it all comes down to the economic data and to the stance of central banks. Now if we look at what’s happened in the US over the last six months there’s been general improvement in economic growth, unemployment coming down, industrial confidence improving. If that continues then by the middle of next year the Fed might be in a much more difficult situation, it might not be able to say we’re keeping interest rates on hold for another year, so the market will start to price in some increases in interest rates maybe, you know, in 18 months of two years’ time.

Presenter: And inflation generally we’ve covered that off pretty clearly so far and the better sentiment. I mean the better sentiment surely is just people sort of having better economic numbers coming through and people just having a better feeling about the outlook.

Chris: Well I think there are two things, there’s better economic data, but also that tail risk in Europe has been kind of diminished. The euro is going to survive for the foreseeable future and at the same time the authorities are providing a lot of support for the economy through monetary expansion. That’s all good for risky assets, so it lends itself to support investment grade credit, I think it’s supportive for equities, supportive for high yield bonds.

Presenter: Okay, so let’s have a look then at the impact of a risk in interest rates, put ourselves in the scenario where we see interest rates going up. The next slide sort of shows sort of some historical data here, talk us through your view on this.

Chris: Well as everybody knows if the yield on a bond goes up the price goes down and the yields on bonds are very much determined by interest rate movements. So if we do get into a situation of central banks starting to raise interest rates the negative price effect will be felt on longer maturity bonds. So a strategy we favour in that kind of environment would be to limit duration and that is keep your exposure to bonds at the short end of the yield curve where the impact of higher interest rates will be less in terms of the price effect. And when we look at previous examples of the Bank of England in this case raising interest rates, it’s the short end of the credit market that’s outperformed. So having that short duration stance is very important when you believe we are into an interest rate hiking cycle.

Presenter: Yeah and looking at the difference between a sharp rise in interest rates and a slow rise in interest rates actually, you know, the difference in the return in the short-dated gilts is pretty or sorry short-dated corporates is pretty minimal. It’s the all maturities area where you start to get a real pain from a slow rate.

Chris: Absolutely.

Presenter: And, you know, just nailing the point for inflation on the next slide looking at the impact of inflation versus bonds. I mean the idea of investing in index linked bonds seems attractive in an inflation environment, but clearly you’re going to suffer a bit on the duration exposure there aren’t you?

Chris: That’s right and if you look at, you know, the performance of UK index linked bonds for example last year the total return was something like 15%. You know, that’s not what you expect from a fairly boring part of the bond market. That was all driven by the decline in the real yields. Now we will get some reversal of that we think in 2012. So your return from inflation linked bonds is really the inflation component. So it’s what you expect in terms of RPI over the course of this year, which is probably still going to come in around 4 or 4½%, so that’s your total return expectation from the inflation side.

Again, we like inflation linked bonds; the chart shows that the historical performance has been excellent against regular ones and also against equities. We think that they offer good diversification for investors, they protect long term portfolio values, but in an environment where interest rates may go up we have a particular strategy related to this, which is our reduced duration share class, which basically takes out a lot of the interest rate risk, so allows investors to still benefit from inflation, but protects them from the impact of an increase in yields.

Presenter: Okay, let’s in the last five minutes or so let’s have a look at some of the product ranges that we’ve got that that meet the duration, the duration example, four funds here split between investment grade and high yield. Perhaps the most successful we’ve had in the UK market has been the US short duration, but there’s other strategies as well which fit into that category.

Chris: Well the theme of all of these is really income investing. So you’re investing in bonds to capture the yield. And because they’re short duration the volatility of prices of bonds is quite low, particularly when interest rates are stable and it’s lower than the rest of the bond market when interest rates go up. So in high yield you’re picking up a significant credit risk premium, which can be, you know, anything from 5-600 basis points above regular bonds, and the same in investment grade credit, although the yield premium is less. It’s all about accessing the income that’s available on credit instruments.

Presenter: So on the basis credit clearly with the short duration strategy credit being the major risk if you take the duration element out. What’s the default rate been like in the markets? What have you experienced over the last 12 months or so?

Chris: Well in investment grade bonds, you know, historically default rate is very, very low, so we have a very positive fundamental view on investment grade, the company sector is in great shape. In high yield the default rate can be more of an issue, but at the moment the default rate is extremely low and it’s hardly risen at all even through the financial crisis.

Presenter: And is that because of the accumulative starts on interest rates and?

Chris: I think the interest rate environment is very helpful; it’s meant that companies can refinance their debt very easily in the bond market, but also I think these companies are very well managed now. High yield is, you know, a mature market particularly in the United States, it’s a very broad and very deep market, and the fundamentals for even high yield companies are very good. I mean they’ve hardly been better in terms of cash flow, in terms of leverage on balance sheets and so on.

Presenter: And looking at the opportunities across this range clearly we’ve got sterling, we’ve euro, we’ve got US, where do you see the greater opportunities?

Chris: Well in terms of yield, you know, if you’re looking purely at yield European High yield has got a bit of a premium still to the US. I think largely because it’s not quite as well developed to market. In investment grade, sterling looks the most attractive from a yield point of view. There’s a nice premium of sterling investment grade credit compared to the US or Europe.

Presenter: Okay and moving on now looking at the inflation linked products, the one that stands out here is the global inflation bond fund as we mentioned the Redex share class which shortens the duration on that as well, but that’s been a strategy which has been very popular with clients; however, you know, the argument always comes back actually we don’t see inflation out there. So what do you think would be the drivers for people to look at inflation linked bonds, what’d be the key indicators you’d be looking out for?

Chris: Well I think, you know, increasingly as globalisation has taken hold inflation is a global phenomena. It’s very unusual to see inflation just taking place in one country these days; it tends to be driven by things like oil prices, other commodity prices, what’s happening in China for example, these things are common to all of us, because they affect prices of common goods. So I think having a global product is very attractive, because it picks up on these global trends. You know, inflation linked bonds have performed very well, even in a world where inflation has been quite low, and that’s because inflation has tended to be slightly above what’s been expected by the market ex ante. So I think we will continue to get positive surprises from inflation and having this kind of asset protects your portfolio over the longer term.

Presenter: Okay, so just to summarise and draw this to a close it’ll be quite useful just to have your overall economic view and where you’re invested, you know, as a fixed income investor in terms of duration, in terms of geographic, in terms of investment grade and high yield.

Chris: Well I think as I said at the beginning the economic outlook is okay, but it’s nothing special. We’re not going to see significantly higher economic growth any time soon. But the quid pro quo of that is that interest rates will remain on hold for quite a long time, so that lends itself to supporting investment grade credit, so spread product and high yield. It doesn’t support government bonds and therefore we tend to have a much shorter duration type of strategy; picking up these credit risk premiums that are still quite wide. Now having said that credit and high yield have rallied quite strongly in the first quarter of the year, there’s still I think a lot of spread tightening to come.

Presenter: And is there a lot of correlation between the high yield market and the equity market.

Chris: The high yield and equity market, yes there is, so I think as long as we’re in this environment where equities continue to do well high yield will do well. I always say it’s a kind of lower risk way of playing the equity market. But I think for the next couple of quarters there’s certainly more juice to be had in credit and in high yield.

Presenter: And in terms of the next quarter or so obviously in terms of economic flow there’s plenty of data coming out, what are the key things that you’re watching out for? What are the key things that sort of keep you awake at night?

Chris: I think in terms of the global economy China is very important, because there’s a debate about whether China’s going to go through a kind of soft landing or something more serious, we’re in the soft landing camp, but also the US economy and particularly the unemployment rate. It has come down over the winter. Ben Bernanke said yesterday that he wasn’t sure that that that would continue, but if it does that’s a very positive sign that at last the US economy is gaining some real traction.

Presenter: Okay, Chris well thank you very much for that and thank you very much everyone for your attention today. Hopefully you’ll be able to join us next month for our webcast, but from myself and from Chris today thank you for viewing.

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