An upward move in rates
Up until mid-June, UK gilts had performed robustly from a total return perspective in 2017, as 10 year yields edged down from 1.24% at the start of the year to hit 0.93% on the 14 June. This translated into a gain of 2.84% from the FTSE Gilts All Stocks Index over the same period. However, there has been a change in tone from developed market central banks of late, particularly the Bank of England (BoE) and the European Central Bank (ECB) adopting a more hawkish stance. For example, the fact that three members of BoE’s Monetary Policy Committee (MPC) voted for a rate rise surprised the market, as did ECB President Mario Draghi’s comments on potentially stopping or reversing Eurozone quantitative easing (QE). As this implied we may be seeing higher interest rates sooner-than-anticipated, the 10 year UK gilt yield duly jumped to 1.31% by the 7 July.
The UK in a global context
The United States has been on a rate rising cycle for some months now whilst Germany – the Eurozone’s biggest government bond market – has also seen upward pressure on yields, albeit from a lower base. However, how has the recent rise measured when compared to the last three years of data? The graph below highlights the rise and fall in ten year US treasury, UK gilt and German bund yields since the start of 2014.
Ten year government bond yields
Source: Bloomberg, as at 07/07/2017.
As you can see, UK and German yields are some way off the highs witnessed at the end of 2013. In comparison, US treasuries are back up to nearly 2.50%. We think it is useful to contextualise these moves through the visual of Fibonacci retracement. This measures the distance between the peak and trough on a chart and divides the vertical distance by the key Fibonacci ratios. Horizontal lines can then be drawn to identify possible support and resistance levels, which often cause an asset’s price to reverse. For example, the below graph highlights how US treasuries are once again approaching the 61.8% level, having previously touched the 76.4% Fibonacci band.
The US rate rise cycle is significantly more advanced
Source: Bloomberg, as at 07/07/2017.
In Japan, growth remained at 0.3% in the first quarter of 2017, confirming the positive growth path of the Japanese economy, which was supported by the pickup in the global economy and the recovery in private domestic activities. Exports continued to increase, with domestic producers meeting strong foreign demand thanks to the upturn in the global cycle. After years of deleveraging and restructuring, Japanese corporates have started investing again as illustrated by the drop in the corporate savings rate. At its April meeting, the Bank of Japan (BoJ) offered its most optimistic assessment of the economy in nine years while maintaining its accommodative monetary policy measures on the back of a still benign inflation backdrop. 10 year Japanese bond yields closed the quarter just below 0.10% and the Yen rose to $113.
In contrast, both UK gilts and German bunds are still yielding below the 38.2% resistance level, but, as mentioned above, the market has been surprised at the more hawkish tone coming from the BoE and ECB in recent weeks, pushing yields up.
The UK & Germany
Source: Bloomberg, as at 07/07/2017.
It is important to bear in mind that institutions such as the BoE and the ECB are run by committees. A feature of committees, which we wrote about back in March, is that they are notorious for being risk averse. The individual members fear being blamed if something goes wrong. We believe this is an important principle which helps to predict the behaviour of interest rate-setting committees.
This year there are nuances in the ways that the different rate-setting committees are acting. The US have now raised rates by a full percentage point since the lows. This is because the US Federal Reserve (Fed) Committee was scared of being blamed for continued high inflation, particularly as growth had long been robust. It is a very different situation in the Eurozone, where it has been such a struggle to generate sustained economic growth. Whilst the growth outlook looks rosier at the moment, the ECB will not want to raise rates, as they fear being blamed were the growth rate to be hit. Furthermore, with unemployment still running at 10%, one would question whether any tightening is needed with consensus GDP growth forecasts at just 1.9%.
In the UK, the BoE has also been concerned around the growth environment, with Brexit now also thrown into the mix. The committee will not want to raise rates just as EU talks break down and the economy takes a hit, for example, as they would be blamed for any slowdown.
This variation in the behaviour of the central banks is helping to create swings between excessive optimism and pessimism in the markets, and is tending to create trading ranges, as yields either break through or reverse from key resistance levels. Following June’s rise in yields, on the 12 July, Deputy BoE Governor Ben Broadbent came out against a rate rise in the UK, saying there are too many ‘imponderables’ in the UK economy. In the US, inflation has now rolled over and the Fed may now revert to focusing on growth. This was highlighted, again on the 12 July, as Fed Chair Janet Yellen suggested US rates are at a near neutral level and might not have to go much higher. Yields duly ticked down in both the US and UK. As mentioned above, we believe these kind of central bank ‘sentiment swings’ will establish new trading ranges across government bond yields as we head towards the end of the year. In sum, there is pressure on bonds for higher yields, but we believe that this will take a while and that there are plenty of twists and turns on the way.
Asset allocation & outlook
So what is the outlook from here and how are we positioned? We also expect these new trading ranges to present fixed income investors with attractive spread opportunities, particularly within corporate credit. As a very recent historical example, UK gilt yields also oscillated in the second half of 2016, falling to a low of 0.52% in August, before finishing 2016 at 1.24%. Over that six month period, the CF Canlife Corporate Bond Fund delivered a total return of 4.11%, whilst sterling corporate bonds, on average, returned 3.43%.
Against this background, we believe that patience is a virtue and that holding good quality companies will ultimately lead to outperformance. Although yields are likely to tick up, the UK and Eurozone economies are solid and we continue to see a relatively benign operating environment for companies. As a result, we have maintained our preference for corporate credit as we are seeing good support for new issues, with spread compression also supporting total return numbers. Financials have outperformed non-financials so far this year given higher yields and we like the insurance sub-sector in particular. Both the CF Canlife Corporate Bond Fund and the CF Canlife Short Duration Corporate Bond Fund are positioned short of their respective benchmarks from a duration perspective and we would not be looking to go long any time soon. Although we do not see the BoE and the ECB committee’s rushing to raise rates, our forecast is for yields to rise modestly in both the UK and Germany over the course of the rest of this year.
Against this backdrop, bonds retain solid defensive characteristics. This is important because higher rates will have an impact across the asset class spectrum. Property could be negatively impact by a higher cost of borrowing, whilst growth-style equities may come under pressure as a higher risk-free rate would struggle to support the expensive valuations seen in some markets. That is why maintaining a diversified portfolio is critical – whatever the interest rate outlook.
Past performance is not a guide to future performance. The value of investments may fall as well as rise and investors may not get back the amount invested. Income from investments may fluctuate.
*Source: Performance figures from Morningstar, bid to bid, with net income re-invested for C share class.
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