Gilt market time machine
Financial markets started the year with a bang. Unfortunately, it was the kind of bang normally associated with car crashes and, unfortunately, stock markets, rather than crackers and fireworks. Bond yields and equities both fell significantly causing further declines in funding ratios.
Just like January 2015 gilt yields fell significantly over the month. Nominal 30-year gilt yields fell 0.32% which was slightly less than in January 2015 where gilt yields fell by 0.53%. There are a number of common reasons for these declines which show that many of the issues faced this time last year have not gone away. In 2015 there were concerns about deflation caused by declining oil prices and the ECB loosened policy as a result. In 2016 the Bank of Japan loosened policy, introducing negative interest rates, and the oil price continued to fall.
However, there is one critical difference between 2015 and 2016. Whereas in January 2015 we were worried about a small peripheral European country, in 2016 we are worried about a slowdown in the world’s second biggest economy. There is little doubt that the Chinese economy is slowing. Commodities from iron ore to oil and shipping are all at multi-year lows as Chinese demand slows. In addition, the Chinese equity market bubble has burst with prices down 47% since their peak in June last year. This will have an impact on the world economic outlook.
Lower demand for some commodities and lower world economic growth rates push down inflation expectations. As a consequence, nominal bond yields, which typically take account of inflation expectations, will fall. This, of course has the impact of increasing liability valuations. In addition, it makes it less likely that central banks will increase policy rates.
Investors in the UK now do not believe that the Bank of England will raise policy rates this year. This follows a recurring theme we have seen ever since the 2008 crisis. Investors have continuously overestimated the degree to which policy rates will move up in the future. Every time it looks like rates will move up a shock hits the economy and puts back expectations. The chart below shows the extent to which investors have continuously got this wrong by comparing the expected level of bond yields in 1 year ahead with the actual out turn level of yields.
Trustees need to acknowledge that there has been a paradigm shift in the level of yields. It is likely to be a very long time indeed before yields reach the levels of 4.5% that we saw in the pre-2008 period. Many of the problems we faced this time last year are still with us and in the intervening period some others have also sprung up. This being the case trustees need to adjust to the new level of yields and possibly re-evaluate hedge levels and / or trigger levels. With policy rates close to zero any additional policy stimulus required would likely contain unconventional policy measures such as QE which could put further pressure on long-end yields thereby lowering funding levels.
Robert Scammell, portfolio manager Kempen Fiduciary Management