Fixed income: the debt disconnect

As the mountainous scale of global debt continues to climb, investors are advised to heed the lessons of the past, argues Chris Higham.

3 minute read

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In October, the International Monetary Fund reported that the level of global debt has surged to a record $152 trillion1. Yet despite this, asset markets remain buoyant, swept along by the largesse of major central banks and expectations of supportive fiscal policies.

Chris Higham, Manager of the Aviva Investors Strategic Bond Fund, discusses the challenge posed to both economic growth and asset prices by record debt and the prospect of tighter monetary policy.

How concerned should we be about record debt?

The bad news is that global debt is still growing and, with the US Federal Reserve expected to raise interest rates three times this year, the burden will become more onerous still. This is not something that investors should take lightly.

The key weapon in tackling the debt mountain is the generation of nominal growth (real growth plus inflation). But where is that to come from given that the global economy is beset by huge imbalances and structural problems? Many investors are now pinning their hopes on fiscal stimulus.

Only time will tell, however, if the $1 trillion that Donald Trump is planning to inject into the US economy will succeed in creating sustainable expansion. Certainly, tax cuts and infrastructure spending have the potential to drive growth, but we should not ignore the potential impact of another key element of the Trump plan: deregulation. There is little doubt that regulation is weighing heavily on a number areas of the economy, not least energy generation and manufacturing. A loosening of these shackles is seen by many as a vital catalyst for sustainable economic recovery.

What are the implications for asset markets?

If the last ten years have told us anything, it is that investors can look through any amount of negative economic data as long as policy makers are seen to have a solution. You only have to witness the euphoria that greeted the cautious guidance recently given by US Federal Reserve chair Janet Yellen as she announced a much anticipated rise in interest rates.

Yellen and the other policy makers are only too aware of the jolt to the markets that was triggered by the ‘taper tantrum’ of 2013. For this reason, the path to policy normalisation is going to be slow and measured, and therefore unthreatening for asset markets.

We should bear in mind that, hitherto, the use of easy monetary policy has been positive for both bonds and equities. But while policy is expected to remain hugely accommodative by historic standards - the European Central Bank is buying €800 billion of assets this year - perceptions of economic growth are now likely to drive a divergence in performance. If the hard data starts to catch up with the very positive confidence surveys we have been seeing, then riskier assets such as equities and high-yield bonds stand to benefit.

Where are you looking for opportunities?

It’s important to be ready to take advantage of the distortions thrown up by the market as the world changes. The financial repression that has been taking place since the financial crisis has had the effect of fundamentally disrupting the risk-free rate on which all assets are priced. It has led to a distortion, or flattening, of the ‘efficient frontier’, which sets the basis for any investment portfolio.

In the context of a flexible fixed-income mandate, the use of unprecedented policy interventions can have implications for risk management. For example, if you are a bond investor who is no longer being compensated for taking interest rate or credit risk, you are able to achieve a competitive yield with a lower threat to your capital. For us, this has meant focusing on relatively secure short-dated senior subordinated debt yielding a steady three or so per cent.

How can you best generate alpha in the current environment?

Bonds across the board have had an amazing run on the back of central bank action. Now, with credit spreads much tighter and government bonds yet to price in the reflationary environment, investors are going to have to work harder to generate returns. In the hunt for alpha, security and sector selection will be vital. In this respect we will seek to avoid sectors that are disrupted by new technology or those single names that are not affected from a credit perspective by M&A.

As the policies of the main central banks continue to diverge, relative value plays will be a further source of potential alpha.  Look at the mismatch, for example, between the US corporate bond market, where there is no central bank purchasing, and the UK and Europe, where there is. We also see the promise of fiscal spending being more positive for corporate bonds relative to government bonds, particularly as governments are likely to suffer more stress on their balance sheets. Stretched finances also weaken the argument for emerging countries relative to developed countries.

How do you think deleveraging will play out?

This is going to be a slow and risky process for the global economy. Europe is possibly the biggest risk because of the huge imbalances present across the economy and the apparent lack of desire to address the distressed economic circumstances suffered by many people in the peripheral countries. The other major challenge is for China to execute an orderly unwinding of a debt that has doubled in size over the last four years.  Investors should also be aware of the risk to the major surplus countries, such as Germany, as global debt rebalances.  

References

1 Fiscal Monitor, Debt: Use it Wisely, October 2016

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