The decision by the US Federal Reserve in September to reverse its crisis-era stimulus programme and raise interest rates showed its confidence that inflation is set to return. For global bond investors, this signals a significant risk on the horizon. With the Fed – as well as other central banks – seeking to remove the proverbial punch- bowl of liquidity and with valuations across most risk assets looking stretched, this year is likely to be a challenging one for investors. In my view, this quantitative tightening, or QT, is a key catalyst for volatility in risk assets. We have had a colossal $15 trillion (£11 trillion) of central bank purchases over the past decade. I believe this stimulus has been the key driver of risk assets since the financial crisis. That’s now set to roll over quite aggressively and, in theory, place pressure on credit spreads. As a result, risk assets could be set for quite a volatile phase for the next year to 18 months.
Is the Federal Reserve behind the curve?
The Taylor Rule is a forecasting model used by central banks globally to guide interest rate policy. According to the Taylor Rule, interest rates in the US should be at nearly 4 per cent by now. The Fed has basically kept interest rates too low for too long. In my opinion, it should have started to raise interest rates a number of years ago.
By leaving policy so loose for so long, the Fed has created new bubbles across shares, credit, property and other assets. At their current lofty valuations, risk assets look vulnerable as the Fed now tries to tighten policy. In addition, the shape of the US yield curve has been flattening over the past year, a worrying signal. Flattening yield curves are associated with slowing economies. The US treasury market could be indicating that QT combined with more interest rate rises may damage the US economy. There is a risk that additional policy tightening could lead to further flattening.
The Fed has justified its decision to start normalising interest rates by arguing that weak inflation is temporary. However, it has been missing its 2 per cent annual inflation target for years. At Jupiter we expect downward pressure on inflation to continue to haunt the global economy.
We believe long-term trends such as the ageing of populations, over-indebtedness and technological disruption are likely to suppress economic growth and inflation for longer than many people think. In turn, these long-term structural factors are likely to keep a lid on bond yields for some time to come. We believe the US is also showing signs of late-cycle behaviour in corporate bond markets. Credit card debt delinquencies have risen, car loan financing has deteriorated and there has been a massive deterioration in the quality of borrowing agreements from lower credit-quality bond issuers in the US (known as high yield), which represents a big shift in power from creditors to debtors.
Global and dynamic approach
So where can a bond investor find opportunities against such an backdrop? Fortunately, Jupiter Strategic Bond fund’s unconstrained mandate allows it to seek out the best opportunities across the bond universe and react nimbly to changing market conditions.
In light of current market risk, we believe caution is sensible, so we have increased the quality of bonds in the portfolio and reduced high-yield exposure. While we favour high-quality developed market government bonds such as US treasuries at the moment, we see a few bright spots in emerging market debt. India is our top pick in emerging markets and one of our top performers over the past three years. It is one of the few countries we have high conviction in and where we favour adding risk. Government bond yields are attractive at about 6-7 per cent. 3 Despite short-term currency weakness, we expect the rupee to strengthen as economic activity picks up following further economic reforms and as Indian interest rates drift lower.
Ariel Bezalel is manager of the Jupiter Strategic Bond fund.
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