Jupiter: Paring back duration exposure
High-quality government bonds have been one of the better performing asset classes in 2016 so far. Renewed central bank stimulus, a challenging global growth outlook and investor risk aversion have all created a near-perfect environment for longer-dated sovereign debt.
The determination of global policy makers to combat deflation via asset purchase programmes and persistently low interest rates is hardly a new phenomenon. However, in the weeks prior to the shock UK referendum result, investors’ desire for safe haven assets’ created a remarkable environment in which nearly $12 trillion of global sovereign debt traded at a negative yield1.
The fund was positioned to try to take advantage of this trend via holding roughly a third of the portfolio in Triple A-rated sovereign debt. While we have avoided markets with negative yields such as Germany and Japan, our positions in US, Australian and New Zealand government bonds have made sizeable gains as yields pushed lower. Having generated strong year-to-date performance, we decided to take some profits on our US Treasury positions in July, selling out of the 20 and 30-year bonds. In the
process, we have shortened the duration of the portfolio from around 6 years to 4.5 years.
Several factors have influenced our decision. From a technical perspective, we are mindful that the policydriven yield compression which has already occurred has limited the opportunity for further upside. For example, the US 10-year yield began the year at around 2.25% but has since fallen steadily, breaking below 1.4% in July. Simply put, at these levels Treasuries now look expensive and risk reward favours taking some profits here.
Conversely, we are also wary of the potential impact that a temporary pullback in yields, like the brief spike we saw in the German bund market last summer, could have on
the portfolio. The impact of such a spike on the long end of the curve at these low yield levels would be significant.
Secondly, stronger US economic data has brought the possibility of a US interest rate hike in 2016 back into play. Recent data suggests that the US economy is now gathering speed after a sluggish first half of the year. Unemployment is below 5%, PMI data for manufacturing has rebounded strongly while the reading for the crucial services sector remains robust. This has given the Federal Reserve the room it was hoping for to consider raising rates again, after the volatility at the start of the year forced it to shelve its plans. At the Fed’s July meeting, Janet Yellen stated that “the near term risks to the economic outlook have diminished”. The market-implied probability of a rate hike in September or December has increased and as a result it seems prudent to take some risk off the table.
Election uncertainty ahead
Looking further ahead, we think the upcoming US Presidential election in November provides investors with little visibility on the future direction of fiscal policy. In our view, it’s possible that either candidate could turn to increased fiscal spending in 2017. A victory for Donald Trump, in particular, is likely to give investors pause. The precise nature of Mr Trump’s economic policy stance is unclear, largely as a result of his unorthodox campaigning style. However, the populist nature of his appeal has fed speculation that he may be inclined to increase spending by running a higher budget deficit, and we think it’s possible that Treasury yields could start to reflect this fear as the election approaches. More worryingly, the sheer unpredictability of a Trump presidency, and the increased likelihood of a subsequent policy error, could itself unnerve the market, which could create volatility. Both these factors influence our more cautious stance with regards to duration as the election campaign gets underway.
The possibility of expansive US fiscal policy echoes developments elsewhere in the world. In our view, there has been a shift in the tone of global policy makers in the weeks since the Brexit vote. The recent meeting of the G20 heads of state in China brought calls for coordinated policies to support global economic growth, and there is a growing sense in markets that monetary policy stimulus alone may not be enough to reflate the global economy. If policy makers conclude that the world’s central banks have indeed run out of bullets, it is possible that expansive fiscal policy, for so long considered an unpalatable option across much of the developed world, could be considered. Such actions appear to be approaching in Japan, where the government recently announced a new ¥28 trillion fiscal stimulus package, while in the UK, the incoming Chancellor of the Exchequer has made clear that he is not bound by the fiscal targets imposed by his predecessor. If such rhetoric is followed by action, there
could be technical pressure on government bond yields via increased sovereign issuance, another reason why we have pared back portfolio duration.
It’s important to add that while fiscal stimulus could provide a welcome boost to economic growth in the short-term, in our view policy makers face formidable long-term obstacles in the form of high global debt levels and adverse global demographic trends could continue to impede efforts to stimulate growth.
High-quality government bonds continue to play an important role within in our strategy and we currently hold a significant allocation to longer-dated bonds in markets where we think there is scope for additional upside. Australia, where the central bank has just cut interest rates by a further 25bps to For professional investors only, not to be distributed to retail clients. 1.5%, is one such market. Inflation has fallen below the Reserve Bank of Australia’s 2% target level as the economy continues to feel the effects of weaker commodities prices. Similar dynamics are present in New Zealand, where a further rate cut is currently expected in August. More broadly, longer-dated sovereign debt continues to play an important role as a counterweight to our credit positions. Over the past 12 months, our sovereign holdings have added steady value during risk-off periods, helping to dampen the fund’s overall level of volatility. We continue to pursue this strategy as we believe that further sharp swings in sentiment, such as those which took place periodically in bond markets in the first half of the year, are likely in these uncertain economic conditions.
Ariel Bezalel manages the Jupiter Dynamic Bond Fund and is a member of Jupiter’s Fixed Interest & Multi Asset team