The liquidity provided by central banks since the financial crisis through conventional and unconventional monetary policy has masked the fundamental imbalances in the global economy. But, as the US ends its quantitative easing programme and moves towards interest rate normalisation, the risk is that the underlying vulnerabilities of a weak global economy are exposed.
Pre-crisis, stimulus for the global economy was provided by demand from the major Western developed economies, particularly the US. China’s export led growth met that demand and the reserves it accumulated as a result were recycled into global financial markets. However, the pattern has changed since the crisis. With the rise of shale oil and gas production, the US current account deficit has been structurally reduced. In Europe, Germany is on course for a record current account surplus this year, equivalent to more than 7% of GDP, which needs to be recycled. China, meanwhile, is slowing as it strives to deal with the fallout from its own post-crisis credit fuelled expansion. To move towards a more balanced global economy, the traditional demand drivers of the US and Europe need to be replaced by domestic demand growth in the rest of the world, but this adjustment is far from complete.
The liquidity provided by QE has papered over these cracks and underpinned a prolonged rally in asset prices, in both developed and emerging markets. There are hopes that the increased monetary expansion in Japan and the potential start of eurozone sovereign bond purchases can offset the withdrawal of the Federal Reserve’s monetary accommodation. This optimistic view, however, overlooks two factors. Firstly, the primacy of the US in setting global interest rates. If the Federal Reserve starts to hike rates next year, the risk is that capital flows back into the US at the expense of emerging market bond and equity markets. Secondly, the dramatically reduced liquidity backdrop in post-crisis financial markets. Last month, for example, we highlighted the 36bps decline in US Treasury yields in one day, an almost 11 sigma event, and suggested that a significant factor in that move was the fact that since 2008 total Treasury notes and bonds outstanding have tripled, while over the same period, market making capacity has declined dramatically.
We also highlighted our own empirical research, which shows that the relationships between macro fundamentals and credit markets has changed. During the pre-crisis period (2000-2007), credit spreads tightened when interest rates increased, but moved wider when inflation increased, while changes in unemployment had a negligible impact. In the post-Lehman era (2008 to 2014), a rise in rates is now consistent with a widening in spreads, while an increase in the unemployment rate also generates spread widening. Rising inflation is still associated with spread widening, but the response is now larger. We attribute these changes to unconventional monetary policy, as investors were forced to take on additional risk as risk-free yields were artificially suppressed by the central banks. What is clear is that credit markets are at risk from both a rise in US rates and/or inflation as well as a slowdown in economic growth which increases unemployment.
The outlook remains highly uncertain for a still weak global economy struggling to adjust to fundamental shifts in global trade patterns. At the same time, divergence in growth and monetary policy between the major global economies is widening against a backdrop of mature trends, high valuations, high leverage and low liquidity. As a result we expect asset markets to exhibit greater volatility in the months ahead.
FUND PHILOSOPHY: LO Funds–Absolute Return Bond
The LO Funds–Absolute Return Bond follows an absolute return approach to fixed income investing. It aims to deliver returns of Cash +4% over a cycle with a volatility target of 5%. The fund is highly flexible in its approach and has the ability to go long and short interest rates, credit or FX based on the team’s views of the markets.
Our investment strategy combines the macro views of the aggregate investment team and the individual skillset and experience of highly specialised portfolio managers. The fund therefore features several specialized sub-portfolios in order to efficiently express all investment views and provide a diversification of return sources.
Gregor Macintosh, LOF-Absolute Return Bond