Expert: Tina Adati, PIMCO
Facilitator: Stuart Cummins
- Monetary policy, exchange rates, fiscal policy, trade and geopolitics are key risks affecting market sentiment.
- After a circa 30 year period of steady rates, the markets are factoring in an interest rate correction.
- A nominal rate rise in the UK would tighten investment grade and high yield spreads.
- Core bond strategies can still play an important role in portfolios; however it is important to be active to manage risks.
Long term interest rates are near multi-year lows. The Federal Reserve and Bank of England are expected to raise interest rates two to three times by the end of next year. The European Central Bank is expecting to slow down the asset purchasing program by the end of next year and follow with an interest rate rise thereafter.
Meanwhile the Bank of Japan expects to raise the 10 year yield target by 20-30bps in the second half of next year and emerging market Central Banks are expected to cut rates as inflation slows.
Overall, this impact of Central Bank rate corrections and the ending of balance sheet expansion would have a direct impact on volatility, spreads and economic growth. The geographic economic landscape is set to a moderate expansion trajectory. However the “market is not pricing in all these rate increases”.
The table’s discussion then turned to individual outcome scenarios and the impact on fixed income markets. With continued economic expansion the expert’s theory maintained that if expected rates remained at current levels there would be further tightening of spreads and lower levels of volatility.
In a situation where Central Banks remove policy accommodation too quickly and choke the global recovery, rates again rise, spreads widen and there is growing volatility in markets. However the best case scenario put forward would be for a gradual removal of policy accommodation. In this event rates rise gradually and spreads remain at current levels.
Conversation amongst the delegates explored the impact of credit spreads at below historical averages.
“With growing pressure to begin fiscal easing, what is the ‘new neutral’ going to be? The yield’s direction of travel (especially given what Central Banks are saying) is upwards.”
The in-house expert view, which focussed on five key areas affecting the ongoing stability of the economic growth rate were monetary policy, exchange rates, fiscal policy, trade and geopolitics. Alongside these, the table then began to explore the impact of normalising policy on their investment portfolios.
The experts were then keen to explore three sets of hypotheses impacting the UK investment markets (for illustrative purposes only), this “scenario analysis provides a nice way to quantify future outcomes.”
Three key scenarios were assessed – (1) UK nominal rates rise by 100bps, (2) UK spreads widen by 50bps (in other markets 25-125bps) and (3) a combination of the above. Delegates were keen to examine the impact these scenarios had on the correlation to other risk factors, namely developed and emerging market equities.
With these scenarios in mind, the roundtable concluded that solutions to improve the immediate pricing impact and the 12 months expected returns should focus on a number of key outcomes put forward by the expert:
- Practice an active bond investment strategy. These strategies can play an important role in portfolios to manage risks. The aim is to provide lower volatility and limited downside risk against other financial assets.
- Reduce portfolio interest rate sensitivity.
- Add alternative sources (credit) of portfolio yield - increase and diversify sources of yield.
- Focus on absolute return or consistent income with outcome focused strategies.
- Central Bank rate corrections and balance sheet contraction will directly impact volatility, spreads and economic growth.
- Investors have the option to become more active – evidence suggests that unlike equities, active bond strategies have generally outperformed passive peers.
- Targeting lower duration strategies comes with trade-offs.
- There is the opportunity to diversify interest rate risk by shifting to credit.
- Finally, build in greater flexibility in to the portfolio – adjust exposures dynamically given macroeconomic views.