Markets have been choppy for a few weeks. There are a variety of explanations for this – concern about higher inflation was a trigger – but basically the sell-off in long bonds reflected a change in momentum and investors’ fears that central banks would not come to the rescue. Ironically, the central banks which expressed concern were in areas with the most overvalued long bonds.
At times like these it is perhaps better to look at some factors that will impact asset classes in the long term but which can get overlooked. One subject that attracted attention this week was various updates on global demographic trends. There seemed to be a common assumption that Covid related lockdowns would lead to a baby boom; this has not happened, and indeed, the reverse is true. Some of the data from Europe is actually quite staggering, showing alarming declines in births in the latter part of 2020. This will compound already poor demographic profiles in a lot of developed economies; even before the crisis the EU had a fertility rate of just over 1.5 (this measures the average number of children per woman) compared with a 2.1 rate which is deemed the level at which populations stabilise. Of course, it could be a repeat of the roaring 1920s – freed from WWI and Spanish flu, there was a surge in births. But don’t bet on it. I think it is different this time: we live in more individualistic times where a national call to increase births will have little resonance with family groups looking at key affordability factors. Care and pension provisions are more advanced and reduce the requirement for more children to support parents in old age. It seems to me that there are some real structural trends that will provide massive challenges – not just in Europe but in parts of Asia as well. Who would have thought that Australia’s population would have shrunk last year? Low births rates are one clear impact of Covid – but the second is also relevant: lower immigration in a lot of countries due to border controls. Outside of the developed economies population demographics look different. Africa, which represented about 10% of the world’s population fifty years ago is projected to be closer to 40% by the end of the century. Coping with these changes will be one of the greatest challenges of this century.
What does this mean for markets? Well at one level it is so far in the future it may not matter. However, this is a real issue that governments will need to face. Bottom line for developed economies: higher and different taxes, later State pensions, lower growth rates and probably structurally higher government deficits. I think that governments in the future will look back and say: was Boris Johnson really able to raise money at a real rate of -2%?
Cash, government bonds and currencies
Cash rates moved marginally higher over the week and sterling reversed some of its recent strength against the US dollar and euro. There were no policy changes from the Bank of England (BoE), with a re-iteration that they did not intend to tighten monetary policy until spare capacity in the economy was reduced and inflation moved higher i.e. sustainably towards the 2% inflation target. Interestingly, there was some discussion within the Monetary Policy Committee (MPC) about the level of spare capacity – one to keep an eye on in future Inflation Reports. On bond yields the BoE observed that recent moves higher were driven by positive news on global growth. This was in line with their outlook which remained upbeat – so no immediate push back to higher yields.
10-year US government bond yields moved higher to 1.67% but longer dated yields actually fell a bit. In the euro area Italian yields nudged higher although the general trend was for flat / lower yields in the core markets. In the UK, yields were marginally higher although there was a rally in the latter part of the week. Implied inflation again moved higher in all markets – and this was pretty consistent across all maturities.
Sterling credit spreads widened over the week and are back to the level at the start of the year. Relative performance across strategies is generally positive with our exposure to secured and asset backed bonds being beneficial in most cases. We continue to like financial bonds, although there was weakness in March, and particularly favour insurance company debt.
New issue purchases included SSE, Goldman Sachs and Medical Properties Trust. The latter is a real estate investor that owns a portfolio of health-related properties. The unsecured bond, rated BBB- by S&P, was issued with a coupon of 3.375% and at a spread over gilt yields of 2.55%.
Slightly wider spreads were seen in many investment grade credit markets over the week. This was also reflected in high yield although spreads remain below year end levels – unlike investment grade markets.
Most activity centred upon high yield and we participated in several new issues including Trinseio, a European chemical company and CGG, a geophysical services company. In addition, we added to our exposure to the secured debt of Carnival Corporation.
I still favour high yield and lower investment grade IG strategies – over the medium term we generally get paid for taking risk. Yes, credit bonds have default and liquidity risks, but government bonds can also be risky, especially when considering the volatility of longer dated bonds. If we consider the longest dated index linked bond for a moment: a move from a real yield of -2% to -1%, still abnormally low by historic standards, would see a price fall of 40%. To be clear, I am not expecting this any time soon and the rise in real yields will be over an extended period of time. But I think higher levels of government debt will ultimately push real yields higher.
Past performance is not a reliable indicator of future results. The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are the author’s own and do not constitute investment advice.