12th August 2014
Brewin Dolphin’s head of fund research Ben Gutteridge explains why investors should not sell their fixed income holdings in haste…
The chorus of Western policy makers calling for tighter monetary conditions appears to grow louder with each passing month and each new data point. At the end of July we saw our own Mark Carney comment that “spare capacity is being used up faster than expected”, cementing the market’s view of a first interest rate hike in November this year. At the same time markets received news of a sharp bounce in both second quarter US GDP and the Employment Cost Index. All of this, combined with a tangibly improving jobs market on both sides of the Atlantic, has made investors quickly turn anxious to the threat of less accommodative monetary policy.
This fear has been most pronounced within high yield bonds where we have seen five consecutive weeks of outflows. Indeed, just last week the selling accelerated when, according to Thomson Reuters Lipper, the sector experienced $7.1bn of additional selling. The net figure for flow year to date is now firmly in negative territory, whilst the year’s gains have been all but wiped out. Does such a market response signal the beginning of something more worrying? At this time our conclusion would be ‘no’.
It is only right that investors behave cautiously during periods of heightened uncertainty, and a modest increase in cash levels amidst such geopolitical strife is a sensible course of action. Ultimately, however, Brewin Dolphin believes that the ‘lower for longer’ interest rate thesis still holds, and that the ‘search for yield’ will return to dominate investor behaviour once again.
On Wednesday we get the Bank of England’s quarterly inflation report which, following Carney’s recent comments, will be scoured for further evidence of this looming November rate hike. Brewin Dolphin has sympathy with the market on this but, given the lack of wage pressures, we do not see the Bank initiating a programme of aggressive hikes thereafter. Any move, instead, would likely form part of a probing strategy in order to see how the economy copes with such an adjustment, as well as a shot across the bow for housing speculators.
Looking to the US, there appears to be more dissension in the Federal Reserve, with several committee members openly less ‘dovish’ than their Chair. However, given the continuing high levels of underemployment, along with muted wage pressure, we still maintain that the Fed is not about to embark on an aggressive U-turn in policy. The Fed may well embark on a more transparent and consistent delivery of rate hikes, as is the case with ‘tapering’, however, the move will still be gradual and the terminal interest rate will be lower than in past cycles.
Short rates, therefore, seem fairly well anchored. This, combined with a general improvement in economic performance and corporate profitability, leaves us doubtful that investors will sacrifice the yield currently on offer in high yield bonds in order to move into cash or government bonds. We are also sceptical that holders of high yield bonds would be motivated to switch into equities, given the pervasive overweight that already exists in this asset class.
To that end, and despite some rather vocal commentary from corporate bond fund managers managing a smaller amount of assets, we are less concerned by the prospects for a flood out of the asset class. Having said all that, given the more hawkish tone coming from some quarters of the Fed and with the noise still surrounding asset flows, it is probably not the right time to be adding to high yield. Patient investors, however, should still be rewarded for their perseverance – though those rewards are likely to be less than they might have received in the past.