Fund in focus: Global Bond July 2024

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Transcript

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[00:00:00] Nick Peters: Good afternoon, my name is Nick Peters, Investment Adviser at Marlborough, and today I'm joined by the Global Bond Fund Managers, James Athey and Niall McDermott. Afternoon, gents.

[00:00:19] James Athey: Hi, Nick.

[00:00:20] Niall McDermott: Afternoon.

[00:00:21] Nick Peters: Okay, so a lot going on politically, and so it'd be very interesting to hear your views on the results of the UK and French elections. And the implications for bond investors.

[00:00:33] Niall McDermott: Absolutely. So, if you start first with the UK, what's worth mentioning about it is the election was a fairly known event with quite a heavily signposted result. So it's fairly unsurprising. We've just seen the Labour Party secure a landslide victory. They took 411 seats and that's been the largest majority they've had since Tony Blair's victory in 1997.

[00:00:59] Niall McDermott: However, the market reaction to this has been fairly muted and that's because we normally see moves happen if there's either a surprise or if the expectation was for something drastically different such as different fiscal policy. And on fiscal policy if you look to the manifestos there wasn't really too much of a difference between what the Labour Party were saying and the Conservative Party's spending plans. It seems very much the case. Everyone's learned the lessons from the Liz Truss mini budget chaos. And on surprises, as I've pointed out, it was pretty much fully expected to be a Labour victory. So very much the case, not really a surprise.

[00:01:43] Niall McDermott: If I contrast that with what we've actually seen in France, we've had snap elections there following the European parliamentary vote and that shows a rise in support for the far right.

[00:01:57] Niall McDermott: So, polls in the French election then had pointed to some quite strong far right National Rally Party gains. In the second round elections that we've just had, the response to that was actually to tactically withdraw candidates by both the left and centre parties in rather an anti-far right drive. So, votes were more concentrated around single candidates.

[00:02:24] Niall McDermott: This actually worked in moving RN to 3rd place, but potentially it worked a bit too well in that the outcome is very split between this left coalition, Macron's centrist party, and Le Pen's far right National Rally, with no one actually having a majority. In some senses for markets, this sort of limbo means nothing too dramatic is going to get done in the near term. So, it's a rather muted reaction until some sort of coalition could be agreed. But what this whole saga has really done is spotlight the French fiscal situation. So these issues around deficits, debt piles, and really a lack of fiscal discipline. They've been known for some time, but now that the cat's out of the bag, markets can't really keep pretending all as well in France.

[00:03:22] Niall McDermott: So, in response to this, after the EU parliamentary elections, we saw French government bond spreads rise over German bunds, and that was as investors sold out of France. So, we took a similar approach on the Monday after the EU parliamentary elections, we exited all our non core EU holdings to favour the more perceived safe haven of Germany.

[00:03:50] Nick Peters: Thank you. That's a pretty radical move. Have you got a view as to when you'll look to get back into those positions?

[00:03:57] Niall McDermott: It's not something we'd be immediately looking to rush back into. It is something that we are quite happy to sit at this late stage in the cycle. We'd be quite happy to sit invested in Germany.

[00:04:10] Niall McDermott: These fiscal irresponsibilities aren't going away anytime soon. We've seen spreads tighten a bit of late, but we consider sort of over the long term, we prefer to be invested in more of the safe haven of Germany, then sort of take a risk with some of the non-core EU bonds.

[00:04:32] Nick Peters: Okay, that's clear. Thanks, Niall.

[00:04:34] Nick Peters: And to round off the subject of elections, we have to also mention the US election upcoming in November. What are the team's feelings about that?

[00:04:43] Niall McDermott: Yeah, so across the pond, there's been quite a lot of focus actually on Biden's health of late. We've been hearing a lot more calls for him to step down, and that was given he had a particularly weak, quite stumbling election debate.

[00:04:58] Niall McDermott: This has meant polls are predicting a Trump victory is more likely. He's leading in the battleground states at the moment. Whether he's up against Biden does remain to be seen. So, there's potential for a change of candidate possibly there. The actual election result though is, it's still a long way off. And in terms of a market impact, a Trump win is, is potentially more friendly to markets. You can look back to the 2016 risk on rallies, his election results. That said, both parties are going to be rather fiscally loose, but ultimately, there are a lot of unknowns of who's in power in the House and Senate when we get there and also, it's going to take some time to pass legislation.

[00:05:49] Niall McDermott: So for us, in the near term, there are more important structural elements to focus on, such as inflation dynamics and the labour market.

[00:06:01] Nick Peters: Thanks, Niall. So, James, that segues very nicely into the discussion we'd like to have around inflation and in the past, you've talked about structural and cyclical drivers that push inflation.

[00:06:14] Nick Peters: Firstly, can you perhaps give some colour on what you mean by structural drivers?

[00:06:19] James Athey: Yeah, sure. Thanks, Nick. So in this context, what we mean by structural really, you know, relates to the structure of the economy, that tends to be drivers, which can be thought of as semi-permanent or certainly persistent.

[00:06:32] James Athey: So, I think a really good live example of a structural driver would be the process of globalisation. Which more recently has become the process of de-globalisation. And these processes really have influenced inflation across the developed world over a period of 30 or more years, in spite of cyclical variations in economies.

[00:06:57] James Athey: So, to give a concrete example, if you look at the clothing sub index of UK CPI, what you can see from the early 90s, over a 20-year period really, is that the level of prices fell consistently and persistently, regardless of the economic cycle. So, this is not price declines. representing, you know, short term mismatches of supply and demand.

[00:07:25] James Athey: Rather, this is the impact of globalisation. Clothing which had previously been domestically manufactured, so in the UK, for example, or, you know, equally in the USA or in continental Europe for those economies, where that had previously been manufactured domestically, actually the manufacture of those goods was being outsourced to the low-cost regions of the world.

[00:07:50] James Athey: Predominantly, but not entirely, Asia. And that meant that manufacturers and retailers were able to pass on their falling cost of production to consumers. In actual fact, those price declines within the clothing sector became so significant that the way in which we consumed fashion items actually shifted in response.

[00:08:09] James Athey: The modern term is fast fashion. Where literally people buy clothes, intending just to wear them one or two times before selling or discarding them, you know, in favour of the most fashionable items. That really would not have been possible without the significant declines in cost that we saw from the globalisation process.

[00:08:30] James Athey: And therefore, that would be described as a structural driver, and it's fair to say that many commentators, many market participants look at the process of de-globalisation and believe that that will be an ongoing inflationary influence in the future and could well lead to higher levels of inflation on average in the future than we've been used to in the past. And I have to say, we on the desk, we have some sympathy with those arguments.

[00:08:58] Nick Peters: Just as an aside, I think my daughters would be very sad to hear that the end of cheap fast fashion, if that's what you're saying. And then let's turn to the cyclical factors. What would you include within those?

[00:09:08] James Athey: These are the things that actually most people probably think about when they think about inflation.

[00:09:14] James Athey: Certainly, most people in markets, when they're analysing inflation day to day, the more important factors are the cyclical factors. They influence inflation over the shorter time horizon. Unsurprisingly, they're things that relate to the economic cycle. So economic growth and changes in economic growth, the state of the labour market, and again, changes in the labour market.

[00:09:35] James Athey: You know, unemployment, is it high or low? Is it rising or falling more broadly, spare capacity in the economy and wages really as an output of some of those other those prior dynamics they're what we think of is a cyclical drivers. They're the things that central banks tend to analyse and tend to have some influence over when setting monetary policy more important for inflation in shorter time horizons.

[00:10:02] James Athey: For sure. And from our perspective, we on the desk here at Marlborough, that's where we are much less bullish, for want of a better description, with respect to inflation. We believe that we are in an end of cycle process. We expect that demand will weaken going forward. We anticipate that labour markets will soften and that ultimately unemployment will rise, as it has been in recent months.

[00:10:30] James Athey: And that process, that end of cycle process, lower demand. looser labour markets, that will pull inflation down at least into the target ranges around 2%. And we certainly think that there are risks that it moves lower, just because essentially monetary policy at this stage could remain too tight for too long.

[00:10:51] Nick Peters: Thank you. Okay, so pulling inflation lower, obviously has an impact on interest rates, and there's lots of discussion of what the sort of natural rate for interest rates could be. Where do you see them landing in say sort of 18 to 24 months?

[00:11:06] James Athey: I'll start off by just sort of expressing some of our hesitations around really the usefulness, if not indeed, you know, the fundamental underpinnings of a concept like the neutral rate of interest.

[00:11:19] James Athey: You know, the reality is that in any economy, an incredibly large and complex system, there are vast numbers of actors, economy wide, you know, consumers and producers, obviously making up the bulk of those. Each of those consumers, each of those producers faces a different reality. They face different choices, they have different trade-offs, and the result of that is that they have different sensitivities to interest rates and different sensitivities to changes in interest rates. You know, think of an example of a retired person who owns their home outright versus a new home buyer who's just joined the housing market and has a large and floating rate mortgage. Just those two people alone will have very different sensitivities to interest rates.

[00:12:01] James Athey: Plus, you obviously have some people are still on fixed rates, others are on floating. Large companies and small companies would tend to face different borrowing realities and different sensitivities to interest rates themselves. All of this is incredibly complicated. The neutral rate tries to simplify by averaging these out across the economy as a whole.

[00:12:22] James Athey: The problem therein lies in the distribution. We would observe that modern economies like the US have demonstrated, particularly over the last 20 years, a significant skew in the distribution of key metrics like wealth, like income, and like profit. And for that reason, we are sceptical that an average concept like the neutral rate is particularly useful in analysing sensitivities, particularly of the marginal actor, which is really what is important when undertaking economic analysis.

[00:13:03] James Athey: So that being said, where do we think we'll be in 12 to 18 months down the line? Firstly, we would say that much of the apparent strength and reflation in the economy post pandemic has largely been a result of a combination of temporary factors which have largely subsided. So, the lingering effects of the global decision to shut down economies in response to the pandemic has led to aggressive fiscal and monetary support in the past, but that is no longer the case.

[00:13:32] James Athey: Monetary policy has tightened. Fiscal support has largely tailed off, at least for now. We've seen significant inward migration to many of the larger economies in the aftermath. We've had significant supply and demand imbalances in globally traded commodities, as well as in domestic labour markets. And so we've seen a significant jump in price and wage inflation, but the forces which took us there have entirely subsided at this stage.

[00:14:00] James Athey: Underneath all of that, we would still observe unhealthily imbalanced economies, as I mentioned previously, between rich and poor and between large and small when looking at corporates. And the outcome of this is that economies are largely struggling to generate. What we would call politically and economically acceptable and inclusive growth outcomes without the use of debt and debt growth. Because debt has played such a significant role in economic growth to date, it is our expectation that economies will struggle to shoulder the burden of high interest rates of the sort that we see in front of us today, and ultimately that will mean that central banks have to ease policy in order to support economic activity going forward.

[00:14:48] James Athey: The other problem that central banks have is that they now tacitly admit that they kept monetary policy too easy for too long in the early stages of the post pandemic era. In doing so, they allowed inflation to really take hold in a way that we haven't seen for 40 or 50 years. And they are now scarred by that experience.

[00:15:11] James Athey: And so as we sit here today, most of the major central banks consider themselves data dependent. And the problem with that is that they are reacting using a tool which has a lag of 6 to 18 months in its operation. So they look at data today which tells them something about where the economy was one or two months ago, and they can only respond with policy tools which will not act for another 6 or 12 months.

[00:15:37] James Athey: And so, the potential for them to make the opposite mistake, that is keep policy too tight for too long, is genuinely real. That being said, as I say, we expect interest rates to come down. We think a base case of interest rates in the 3% range seems reasonable. Potentially, central banks have learnt that zero rates is not a desirable destination, and therefore they may be a little more cautious in cutting rates because of their inflation experiences of recent times, because of the distribution effects of their ultra easy policy in the post global financial crisis era.

[00:16:16] James Athey: But ultimately, lower rates as central banks respond to waning growth momentum and waning inflation momentum are certainly our base case, and we think risks are towards lower than the market is currently discounting at the minute.

[00:16:32] Nick Peters: Excellent, thank you. So, I feel the need to bring everything together for our Dear listener, we've got the elections leading to short term volatility.

[00:16:41] Nick Peters: You've got the cyclical factors you mentioned, and obviously the sort of underlying structural factors. I mean, how do you position a bond fund for the waxing and waning of those different areas? And which of the three levers that you can use is working hardest right now?

[00:16:58] Niall McDermott: Absolutely. So as James has mentioned, economies are not really going to be able to shoulder the burden of higher rate environments indefinitely. So, you've got markets pricing in this high probability of rates remaining quite elevated, but quite a low probability that we'll get bad economic outcomes. So our belief is, is an attractive time to pose both of those market consensus views. You've mentioned the levers, Nick.

[00:17:26] Niall McDermott: Ultimately, we use all three of these. So that's rates, our credit beta exposure, and our currency exposure. And we're using those across various time periods to maximize our opportunities for adding value. So, James has explained this late cycle dynamic. We've been favouring a defensive position. So, we've been reducing our credit risk and moving up the quality scale.

[00:17:51] Niall McDermott: And at the same time, it's looking like rates will need to be cut. Possibly by more than markets are expecting over the medium term. So we've moved to a long duration position. We're seeing value really across all three of the major markets. That's the UK, the US and EU and as I mentioned earlier, we've exited all our non-core EU government bond positions to favour that relative safe haven of Germany.

[00:18:18] Niall McDermott: Here we think political instability could, I guess, really continue to increase focus on the fragile dynamics of the EU. For that reason, we've gone short Euro dollar, really bring it together. Overall, we've got quite a defensive portfolio. We think the risks are currently not all priced in and bonds are looking really quite attractive at this point in time.

[00:18:45] Nick Peters: Excellent. James, Niall, thank you very much for your time.

[00:18:49] James Athey: Thanks, Nick.

[00:18:50] Niall McDermott: Thanks, Nick.

[00:18:51] Nick Peters: That was James Athey, Niall McDermott, Global Bond Fund Managers. And if you'd like to hear or see more about the fund, then please go to our website. Thanks very much for joining us and goodbye.

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