EU exit, Inflation, Interest rates and a look at the markets
- Gilts and high grade (AAA rated) Bonds
- Corporate and lower grade Bonds
- Equities (Shares)
- Other assets
Gilts and ‘high grade’ (AAA rated) Bonds
Our vote to leave the EU will have some important implications for all markets not least being Gilts and other Sterling denominated Bonds. But before going into the future prospects for the latter I thought it may be useful to go back to the basic mechanics and principles of investing in Bonds with particular reference to simple risk v return and historical trends analysis, and then to see if this helps identify what forces are in play now, and what the future may have in store for a UK investor.
What are the theories?
Traditional investment theory suggests that the basic risks for all long term Bond investors are based on a few core ideas,
- the risk that whoever you lend to won’t pay your money back (default risk)
- what will this could be worth in real terms after adjusting for rising prices (inflation risk)
- what your asset could worth in any point in the future should you wish to sell (including volatility, market and interest rate risk)
In theory an investor (in any asset class) with a low appetite for risk should always be prepared to accept that their rate of return will be lower than someone who is prepared to take on a higher risk. That principle in itself is quite easy to comprehend. However it brings a much harder concept to get to grips with; how to properly understand exactly what the risks are before considering what sort of returns you could expect (and vice-a-versa).
As a starting point or benchmark the textbook analysis suggests it is helpful to first recognise the idea of a ‘risk free’ asset then to consider, what asset could best fits this description. In markets such as those we are experiencing at the moment it is important for investors to re-examine all possible risks to avoid being carried away with the human emotion element that can often occur in short term volatile markets.
In the UK the return on a 10 year Conventional Gilt is considered as good a benchmark as any or a proxy for a ‘risk free’ asset. The credit worthiness UK Government can never be 100% certain but is about as ‘cast iron’ guarantee or security as you can get for a UK (Sterling) investor and is reflected in an ‘AAA’ credit rating. The Bank of England issues Gilts as well as our bank notes and coins, and has never in history has it defaulted on either of these.
The main risk really that cannot be avoided by using the 10 year Conventional Gilt benchmark is inflation. This has been a feature of economic life since records began and is a reflection of what’s going on in the economy and the prices paid for goods and services. If other risks are assumed as negligible, this leaves the main risk for an investor as the amount equivalent they will lose out by from rising prices. It would follow that the 10 year Gilt return should simply be a close replication of inflation risk. Hence if you expect inflation of say 2% then your long term return (via interest) should be expected to be at least around the same figure to compensate, i.e. 2%.
How has this correlation idea looked historically? If looking at the chart below the rate of return on Gilts has pretty much mirrored those of the inflation rate since 1945. Over a longer period (since 1900) the average return on a 10 year Gilt has been around 4%, with average inflation only very slightly lower at 3.8 %. Not only are these averages similar but the timing of the rises and falls has been fairly close too. The difference, 0.2%, being the sum of the other relatively incremental risks – credit risk, volatility risk etc.
It is not surprising therefore that economic theory focuses on this very close correlation between the projected inflation rate as a guide to future yields on Gilts and in turn, interest rates. So really one can view the current (running) yield on a ‘high grade’ Bond or Gilt as predominantly an estimated ‘compensation’ figure for the expected loss of real value resulting from inflation, plus small increments to cover other risks.
The 10 year yield currently stands at below 0.80% (6 July 2016) and RPI was at 1.4% for May 2016.
How are returns on Gilts paid?
On looking at the mathematics, Gilts and other dated ‘high grade’ bonds are stocks are those that are issued at ‘par’ and redeemed at the same ‘par’ value at an agreed date in the future. The only return possible if held for the duration comes from the interest or ‘coupon’ which is a rate that is pre-determined and fixed over the full period. It therefore implies that it is mathematically impossible for a long term investor (holding from issue to redemption) to ever make a capital gain in a ‘dated’ Bond.
However if Bonds and Gilts are traded during their life there is always the potential for short term gains or losses for investors. But wherever there is a ‘winner’, there is always a ‘loser’, which must be an exact and equal total on all trades from issue to redemption in any dated fixed rate Bond.
If you have held any Bond, Gilts or other Fixed interest (Direct or via collective fund) over the last 25 years you will probably disagree with the above idea and argue, based on your own experience, that capital gains on Gilts/Bonds are actually an expected or standard feature, and generally a ‘par for the course’ experience. Recent history may hint that this is a logical conclusion. During this time capital values have risen in reflection of falling inflation and yields, and there have been plenty of opportunities to make capital gains during this time. Based on this it would be easy to expect that gains on Gilts were indeed the long term norm.
How long can this go? Or to put it another way, was this experience (i.e. 25 years +) just a short term phenomenon that ended up lasting much longer than originally thought, or actually the sign of a new long term trend in Bond market and inflation thinking altogether?
If you believe the former, then the last 25 years would be seen as just an extended short term occurrence. It was a reflection of times where there has been a very ‘favourable wind’ for Bond investors, or described as the textbook ‘glory’ scenario; inflation and associated interest rates starting from a high base, then falling. Yields on Gilts were 14% in late 1970’s/early 1980’s, and despite the blip in 1990’s have fallen quite steadily to below to the current figure of 0.80 % (6 July 2016).
It would also follow that the ‘nightmare’, very ‘unfavourable wind’ scenario, for a Bond investors could be just round the corner. In simple terms this is the exact opposite; inflation and interest rates starting from a low base then rising.
The question is, has that point been reached? On the basis of pure mathematics the Gilt yield (0.80%) is now considerably lower than at any point since WW2, and the inverse relationship with prices has meant that prices of Gilts are at similar all time highs. If a reversal starts to happen Bond prices will fall and capital losses will be the new ‘norm’.
Change in Bond market thinking, need to re-write the textbooks?
However if you disagree with the above you might believe we have entered a new era or long term trend in Bond markets, or you could be the ultimate optimistic Bond investor believing their ‘safe haven’ status remains even stronger than ever and that Bond yields will fall further and prices will still go up.
It would also suggest you are now prepared to accept no more than a 0.80% return for a very long time, that you expect inflation may possibly turn into deflation, and that all all other risks (credit, volatility etc) associated with the UK Goverrnment finances, Gilt creditworthiness will remain negligable. To add to this too, you must be extremely confident that the Bank of England will still be able to keep inflation completely under control should it ever show signs of going above its target of 2% (point discussed below) and that interest rates are unlikely to be above 0.50% at any time in the foreseeable future.
If you believe all this you must conclude that history can be ignored and ‘things are very different now’. If you believe they are, it’s time to re-write the textbooks!
Can the Bank of England control all inflationary forces?
Whichever the conclusion, there is the assumption that the Bank of England will try everything in their grasp to control the vital variable for Bonds, i.e. inflation. That assumption seems fair, but it does beg a bigger question; are they actually capable of doing this, and do they really have all the required tools at their disposal.
Can we believe that the Bank of England really can control our own domestic inflation from all external inflationary forces now that we plan to leave the EU? Or is our inflation likely to be more at the mercy of what is going on in the US, European and World economies, World politics and general Worldwide commodity prices, from which the Bank of England may soon have much less control of.
Since the finanacial crisis in 2009 the UK Government and the Bank of England have pumped vast amounts of money to promote liquidity into the economy which so far has not engineered anywhere near the levels of growth intended. On the basis of this, can we then really trust in their ability to control inflation were this to happen?
If we did see an unexpected rise in worldwide prices in staple commodities (quite possible from a low base at the moment, and quite possible too in that it has happened before – crude oil prices rises of four fold in the 1970’s were a big cause of UK inflation). An unexpected rise in UK GDP growth on the back of higher global economic growth rates is very possible too, as is a rise in inflation from a weak £ Sterling (already down 10% post Brexit vote). Leading Investment Banks have already pencilled inflation rates of 3-4% for 2017 and 2018 on the back of £ Sterling weakness and higher $ Dollar denominated commodity prices. Have Bond investors noticed what the potential effects of this may be on yields?
It would be wrong to underestimate the potential for inflation moving upwards in the UK. Given the historical average of UK inflation at 3.8%, it wouldn’t be too surprising if the inflation number were to move back in line with history.
The additional risks of our current position – the gearing effect
Even such a relatively small increase of 1% in numerical terms might not seem too significant, but this is a very significant rise in percentage terms; a rise from 0.80% to 1.80% represents an increase of 125%. If looking at the inverse relationship in yield/price, this implies a very significant potential fall in Bond prices of up to 56%. In other words the gearing effect can have a very big impact and mathematically puts Bond holders in a very dangerous position if tinkering in +/- increments when the start point is in the 0.80% territory. It is like playing with fire. This is very different to the days in the past when a plus or minus 1% was calculated against yields of say 8% ; that implied prices could move by around by no more than 10 – 12.5%. Even more dangerous when you add in the current political and general economic uncertainty.
History too can show us the mathematical danger well; any investor who bought a Gilt in the early 1960’s had a very torrid time back then. They saw their capital value shrink by up to 75% in the years up to 1975 when interest rates rose from 4% to 16%. What capital value they had left was then savaged by inflation which ran at anywhere between 10% and 25%.
People can talk of ‘the fall in Equities in August 2000 that took 34 months to recover’ to remind us of the dangers of equities. That’s fine, but if I had been around in 1960 and invested in Gilts it would have taken me considerably longer than that to recover my money! On the same theme, if I had bought the undated Gilt, War Loan 3.5 %, in 1945, I would have had wait (and still be alive) in 2015 when it was finally redeemed for the same price it was issued at. Extreme use of numbers perhaps, but probably a good example of the dangers to anyone who thinks that Gilt and ‘high grade’ Bond investing remains a relatively safe pastime. At current yields and prices and the current uncertain political and economic climate, the risks should be there for all to see.
Diversification and risks
Collective Bond Funds. The belief that by investing in ‘high grade’ Collective Bond funds (rather than direct) investors may be protected using the diversification argument should bear in mind that the same inflationary forces will be in play across all the underlying investments within the fund. If the fund is classified as ‘high grade’ this itself represents a fairly homogenous characteristic (i.e. by reference to credit) and as such the investments be equally vulnerable to the same macro-economic dangers. The only diversity possible in ‘high grade’ end is to vary the coupon, the redemption date, or maybe currency of denomination of the underlying stocks – otherwise they are at the mercy of the same danger, inflation.
It will need a very shrewd ‘fleet of foot’ fund manager to negotiate their way forward if the wind does change direction. The choice of fund and manager will be crucial and investors should be wary that past performance records will be of little help in gauging their future ability if things do go into reverse.
Asset class diversification
The idea that including Bonds as a means to diversify risk away from other assets such as Equities in balanced portfolios by having a non-correlated or negatively correlated asset still is probably a reasonably valid argument and historical numbers tend to back this up. The case for assessing the risk of Bonds should always follow that holding this asset reduces overall risk in that it creates stability through diversity in balanced portfolios, independently of whether it may or may not be a ‘safe haven’ investment class in its own right.
However the idea that investors flee to the ‘safety’ of Bonds when markets wobble, may soon be a very questionable practice. Given the above arguments it begs the question; which is the riskier asset class at present, Bonds or Equities? The prices investors are paying for Bonds is becoming a risk in its own right and the question must be in current markets; are investors mindlessly overpaying for the perception of safety in Bonds? Could it be possible that that in the next market wobble Investors flee from Bonds into Equities? The answer could now be a possible ‘yes’. It does after all, fit in with the negative/ non-correlation behaviours of these asset classes in the past!
In recent times the biggest year on year fall in Equities was 43% in 1974 followed by 28% in 2008. The biggest year on year fall in Bonds could be just round the corner and it may just be caused by a slight increase in inflation expectations. If this leads to a consequent rise from 0.80% to 1.80% in Gilt yields (potential fall in prices of up to 56%) that would be enough to smash the record books. The previous worst was 19% in 1916.
The best that can happen to Gilts/Bonds is that inflation falls further and stays lower for even longer than those who think it will stay low for a very long time. Not an impossible outcome which hints at the possibility of deflation too, but very dangerous for Bond holders if this doesn’t happen. Mathematically it is very difficult for the yields to get much lower and this is not the outcome any economic policy makers want and will almost certainly resist with further rounds of ‘quantitative’ easing which is itself likely to be inflationary, if it works.
The behaviour of Bond markets has serious implications for other areas; Residential Mortgage market, Annuity rates, Pensions and Commercial property yields to name but a few.
Corporate and lower grade Bonds
In theory these (Corporate Bonds) should carry much greater risk than Bonds of the ‘high grade’ variety in that they add a completely new risk; the risk of default, or the risk you won’t get all your money back. This risk deserves additional compensation and offering a higher return (via the interest payable), and to add to the part of the return at risk from inflation.
However unlike Bonds at the high grade end they can be invested in a much wider, non-homogenous range of companies and organisations and if done via a Collective this can add much greater diversity and flexibility than their ‘higher grade’ counterparts. As a result this can significantly lower the overall risk in a Collective Corporate Bond fund.
There are the same dangers to Corporate Bonds in relation to inflation, but these funds are much less geared to movements in inflation. The yield on the each of the underlying stocks within a fund is more dependent on the creditworthiness and security of that company rather than the underlying rate of inflation. The ultimate choice of company to invest in is absolutely vital. The current skills required of a Corporate Bond fund manager now are perhaps more akin to those of an equity fund manager rather than an economist.
Yields on Bond funds are typically in the 6-8 % range so less vulnerable to a 1% move in yields compared to a Gilt yielding 0.80 %. The ability of the fund manager is the key, and whilst these funds are not without significant risks do other some possibility of some half decent returns for those accepting and understanding the default risk aspect.
At the moment the UK stock market is the only domestic asset class that is ‘batting’ close to its long term valuation averages based on basic P/E and yield numbers. Going back to the textbook, equity prices, unlike bond prices, have historically always benefitted from worldwide GDP growth, population growth, inflation rises and productivity/efficiency/innovation improvements. Over the last century these combined have allowed UK corporate earnings and share prices to grow on average at 6.8 % per year. If you were a long term equity investor and you see no reason why these principle factors should not continue for the foreseeable future, then it would be foolhardy to ignore the attractions of shares as a long term investment asset.
The only slight worry for me is that a few investors seem to be focussed on valuing a few of the leading so called ‘safer’ shares in the UK stock market using the similar value and yield criteria as they do for Fixed interest markets. There have already been some quite big swings in share prices in the current reporting season on the back of some fairly inconsequential, non-earth shattering trading news. It may be that is evidence that there are currently some very big bets being wagered on some very small +/- incremental outcomes with the some of these ‘safety’ or ‘blue chip’ shares being the most vulnerable.
That being said there are plenty of decent opportunities on offer at the moment and in a wide diversity of industry sectors and really no different than the way it always have been. There does look to be plenty of value opportunities and potential returns for those who are prepared to accept some of the risks involved. The trick of course is identify what the opportunities are, and when to buy/sell these. That’s what risk v return is all about and the key ‘skills test’ for investors and investment/fund managers alike.
Those companies that are mainly exporters of finished goods to Europe (and beyond) will feel the recent fall in £ Sterling will help, those that mainly import basic goods and materials may find life a bit tougher.
Cash on deposit. For those also who think a short/medium term tactical switch from Cash on deposit into other income producing assets such ‘high grade’ Bonds or Bond funds, to get a better rate of interest is a good idea too, they must now accept that this now carries quite considerable additional risk. Capital protection is a vital aspect of money on deposit for those that have little or no capacity for loss. ‘High grade’ Bonds, Corporate Bonds or Equities do not offer this same capital protection.
For those that do wish to protect their capital and who classify themselves as ‘low risk’ then money in Bank or Building Society is probably the best option however uninspiring rates are at the moment.
Summary – all markets
At the moment the biggest ‘risk’ paradoxically may befall those who chase and overpay for so called ‘low’ risk assets and still expect a decent return. Fear and greed have always been the most powerful driving forces behind most market decisions. In these markets it looks like fear has the upper hand and those investors who are worried about it may, funnily enough, end up being a victim from trying to avoid it by paying too high a price. After all paying too much for something is one of the biggest risks for any investor in any investment class.
If comparing current markets to riding a bike, if you worry about falling off, you probably will. If you still worry about falling off then don’t get on one in the first place.
Those investors who are not fearful and those who can understand and accept the inevitable risk associated with the pursuit of return might end up being nicely rewarded for those risks they have taken. For me Equities look by far the best choice at the moment for those seeking reward for risks taken. Careful scrutiny and research on Collective Corporate Bond Funds should be well rewarded too.
Views of Seamus Wild, Director, 6 July 2016
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