Sourcing returns in an era of Central Bank stimulus withdrawal

Dickie Hodges, Head of Unconstrained Fixed Income at Nomura Asset Management UK, gives his macro and markets view on the world including wage inflation, Brexit and European fiscal union.

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  • 15 mins 47 secs

PRESENTER: I’m now joined by Dicky Hodges who’s the Manager of the Nomura Global Dynamic Bond Fund to get his macro and markets view on the world. So, Dicky, good to have you with us today. So I want to start with wage inflation in the United States, why are we not seeing this?

DICKY HODGES: Well I think you are seeing levels of inflation coming in, wage inflation coming in, albeit it’s relatively subdued. And certainly it’s not running at an elevated level which would cause the Federal Reserve some concerns. We also know that the level of unemployment is at 4.4-4.5% which under any normal circumstances historically would lead us to see a higher level and certainly a sustainably higher level of future inflation. The reason I put this down, I surmise, is down to the level of quantitative easing. And again this is in the relationship with the Phillips Curve. Essentially quantitative easing has broken that relationship between the level of employment and the level of inflation.

Now, you’ve seen what quantitative easing has actually done is actually increased the level of asset price inflation. And this is evident from the level of equity markets, from the level of bond yields. And I think essentially central banks need to move back away from quantitative easing so that this relationship with the Phillips Curve re-establishes itself. So that the driver of inflation is actually the low level of unemployment rather than any future levels that they might be trying to create through quantitative easing – which ultimately from my opinion all that has done is prevented the world from defaulting for the rest of this decade, rather than actually generating future level of inflation.

PRESENTER: So what sort of implications then would you say this is having for the Fed and are you forecasting more rate hikes in the foreseeable future?

DICKY HODGES: Very much so. I mean I still think there’s a great probability that we need to see two more rate rises for the remainder of 2017. This, however, is not being discounted in capital markets and certainly not discounted in global equity markets I would suggest. The reason why we need to see further rate rises has nothing to do with the dynamics of slowing economy or rolling over of things like the PMI indices and the US; it’s all to do with the Federal Reserve needing to move away from their emergency monetary policy and the stimulus that they’ve actually added to asset prices. And I think you can see the market actually start moving in the latter half of this year certainly in the final quarter of 2017 to start believing that the Federal Reserve have more to do, and that would suggest that in many cases valuations at the moment are marginally overstretched. But I think this momentum is still here but certainly that’s not discounted by capital markets currently.

PRESENTER: Well it’s certainly still in a low rate environment, so do you think this trend of the hunt for yield is set to continue?

DICKY HODGES: I think so. The problem with the hunt for the yield is this has been, you know, you need a stimulus for this to continue. You need essentially we’ve been investing on the basis and the premise that the interest rates will stay lower for longer. And if you look at many asset classes you would argue that they’re fairly to overly-priced for the conditions that we’re currently seeing. If you look at high yield market in the US, which has been an investor’s favourite place for investing over the course, certainly over the course of the last two years, you know, the all in yield available on our US high yield index is circa 5½%. You know, this, one would argue that if you see interest rates rising and you see the consequence of rising government bond yields then certainly some of these asset classes at this moment look overvalued. But I think from this perspective, you know, given the information that’s here, given the slowdown that I see we’re moving into with the US economy, you need another injection of expectations that will prompt that continued search and hunt for yield, and I think that will continue for the remainder of this year.

PRESENTER: And moving over to the UK now, and we’ve recently seen actually a drop in inflation, which is the first time since August 2006, and people have said that this has almost taken the pressure off the Bank of England to have to raise rates to combat prices. Would you say this is fair and do you foresee a rate rise in the UK?

DICKY HODGES: Well again I think this boils down to, you know, it’s nothing to do with essentially the economy. The central bankers and certainly globally central bankers have done an awful lot to stimulate growth, to encourage investment, to encourage a measure of wage inflation coming through. The fact of the matter is the market doesn’t perceive that this is sustainable. Regardless of some of the comments that we’re coming out from some of the central banks and certainly from the Bank of England and the markets interpretation that this means we’re at the beginning of a longer term interest rate rise in the UK, I think it’s still early to expect this to come through. If anything, I think we could possibly see one interest rate rise in the remainder of 2017. But again this is more to do with removing the cut that we saw last year as a result of the Brexit exit that we had. So I do think that you are going to see the possibility of interest rate rises but essentially in the UK it’s more likely to be in my opinion one and done.

PRESENTER: And the ECB that’s had a more hawkish stance of late, would you say that’s justified?

DICKY HODGES: I think we have to accept the fact that quantitative easing can’t continue for a prolonged period of time. Again, because the effect of quantitative easing has not been to generate a higher level, a sustainable level of inflation; quantitative easing has had the effect of asset price inflation. And we’ve seen considerable returns out of high yielding asset classes and indeed the equity markets. But the fact of the matter is I think the quantitative easing that we’ve seen has been down to prevent the world or certainly from Europe from defaulting until the end of this decade. And I think from this perspective it’s still too early today to suggest that we’re going to have a meaningful pullback from the stimulative measures that we’ve had coming from the ECB. And if you look ahead for the rest of 2017 and into the first half of 2018, we still have what we perceive to be risks ahead of us.

We still have the German elections. And then ultimately into 2018, we will be having some Italian elections between February and May of next year. And I think the ECB need to, you know, they’ve been trying to suppress volatility. They don’t particularly in my opinion want to see significantly higher levels of government bond yields. And so I think that the withdrawal of quantitative easing before the end of this year is highly unlikely. And indeed, I think, Mario Draghi and the post the ECB announcement today, I think he’s even suggesting that the level of quantitative easing which many thought would begin to taper will actually be sustainable right through to the end of 2017. So in that scenario it means you see lower government bond yields, you see support for riskier asset classes, equities and credit markets until we begin to start focusing on the next event, and the next event after that will be the Italian elections early in 2018.

PRESENTER: Now, moving onto Brexit, which is definitely the great unknown, how do you see these negotiations playing out and what sort of impact will they have on Europe?

DICKY HODGES: Well I mean you’ve got to look at where we are at the moment. We are in the allotted time for us to actually negotiate a Brexit with the European Union. We’re a sixth of the way through that negotiating period and we’ve yet to even get to a negotiating table. So, I think, from that expectation, you know, the market is perceiving that we will be in for a harder Brexit. If you wrap this up with the potential economics, you know, impact in the UK, I think you’re still seeing a level of subdued growth in the UK. And I think with a subdued growth from the UK and the demand for UK product that Europe has, this will also have an impact on the balance sheets of the European economy as well.

So I think it’s a very fine edge between how well the Brexit negotiations go. But ultimately I think that this will have to, the negotiation period will have to be extended, because I find it very unlikely that we can meet some, any sort of agreement over the course of the next 12 to 15 months in the time that’s allotted to us. And as you’ll see in many companies around London are now pre-empting a hard Brexit, and that’ll again have greater implications on UK growth as we move forward into 2018 and into the end of the decade.

PRESENTER: Now talk me through your view on high yield asset class. Would you say it’s overbought?

DICKY HODGES: I think when you look at a high yield you have to look at it from a relative perspective, and many people will talk about this. High yield relative to German government bonds or other European government bond markets look attractive from a relative perspective. From an absolute perspective, looking for a level of income and potential capital return, I think there’s very little left in the European asset class. Essentially what we’re trying to do, you know, we’re trying to get as much income and still to your point about the hunt for yield, as much income as we possibly can out of an asset class. But I tend to believe there’s very little room for greater performance to come out of any European high yield. That doesn’t mean to say that I’m not holding European high yield.

It’s very selective in what we’re doing. But if you’re looking at the all-in income on a European high yield index, much as the same way the US, you’re looking at little over 2½% for a high yield market that’s a BB, B. This doesn’t mean that an asset class will suddenly get cheap, however, but it does mean that until you have the dynamics of changing in quantitative easing, the dynamics of maybe interest rates moving higher in Europe, which is very unlikely for the foreseeable future, certainly for 2017, then I think this whole dynamic continues. So high yield I think there is a place for high yield in a portfolio but I think you have to be very, very selective out of this. And certainly the way that we’re positioned, you know, I don’t hold that many positions in high yield, but these tend to be some of the core positions and I don’t see much attractive about the asset class generically.

PRESENTER: So where are you find value or indeed seeing opportunities?

DICKY HODGES: Well again, certain aspects of the US high yield look very attractive from my perspective. But again these are very fraught. The dangers of investing in high yield in an environment where potentially the Federal Reserve in my opinion could still possibly raise interest rates another two times in 2017, means it’s less so attractive as an asset class per se. What we’re also looking for and what we’re also looking to invest in is things like some of the emerging economies. This has been a great trade for, since the beginning of 2016 or certainly since the middle of 2016, and you’ve seen an awful lot of money move into that asset class both from a debt perspective but also from an equity perspective. I think much of the capital return has moved out of this asset class and what we’re now looking at is essentially the carry that is available.

At the moment, where the portfolio is positioned, I hold a reasonable exposure to things like Indian rupee bonds, essentially Masala bonds. The nickname Masala bonds, you know, they’re tradable, they’re settled in US dollars. But the fact of the matter is you’re looking at two, three-year bonds yielding in excess of 7%. And I know people tend to think that India might be perceived as a riskier asset class than certainly US high yield, but India has circa 65% debt to GDP ratio, which is very attractive. Of that there’s only something like 42% is public debt, of which there’s only 3 or 4% external debt. You’ve seen significant stabilisation in the Indian rupee currency and I don’t see any reason why that should change. And if you look at the economy, you know, inflation, there’s some immeasure of inflation in there and you’ve got growth over the course of the next two to three years, anywhere between 7 and 7½%.

So, if I’m looking from a perspective of capital allocation, I would prefer to invest capital in somewhere like India than I would do investing in US high yield. It doesn’t mean I’m negative on US high yield, but it’s all about the allocation of capital where you can generate more efficient and less volatile returns.

PRESENTER: OK so let’s focus on your strategy for a moment now, and how does that perform in a rising market versus a falling market?

DICKY HODGES: Well I think the benefit of having a dynamic bond investment is the fact is it’s our choice as to where we perceive we’re going to generate returns, whether it’s going to be from riskier emerging economies or indeed high yield or indeed interest rates. I would suggest that the interest rate sensitivity that I’m managing on the fund is significantly less than the sensitivity that you would have on a typical corporate bond fund. What we also look to do is looking at where you see significant moves in capital markets. To actually take advantage of these moves to actually add some measure of interest rate sensitivity but I prefer to do this through option markets. You know, buying calls for instance on German government bonds. We saw German government bond yields rise fairly significantly over the course of the last two months.

At the stage of this rising we’ve been buying calls on US, on German government bonds, on bund markets, buying calls on US interest rates. The benefit of this is I know exactly how much the drawdown, essentially the cost to performances at the time of implementing these strategies. And we have the ability of generating returns in both rising interest rates, rising government bond yields environments and not just falling government bond yield environments. The problem is we’ve been a bull market for fixed income asset class pretty much since 2008. And I think trying to generate returns when there’s very little returns left on the table means you have to have a much more flexible approach to managing both interest rate risk and the credit risk that’s inherent in most people’s portfolios today.

PRESENTER: So considering this point of the cycle we find ourselves in, you know, where can people put their money?

DICKY HODGES: Well I still do find levels of attractive, I still very much positive on some areas of the emerging markets politics aside. But from this perspective it’s more to do with looking from the carry rather than looking from returns that are possible from capital. I think many of the emerging economies and many of the emerging debt markets have moved away from this capital generation more into a carry perspective where essentially you’re just generating a level of income. And I think that will be persistent up until the point where we perceive that US interest rates are likely to go higher. So I think some areas of the emerging economies, some parts of the high yield markets, I still prefer US over Europe; albeit I think both asset classes tend to be fairly if not overly-priced. But certainly there are areas where you generate returns from both being long interest rate risk and also being short interest rate risk. Again, it’s all about where you want to take that exposure.

PRESENTER: OK finally one last question for you. And European fiscal union, do you ever see this happening?

DICKY HODGES: Yes very much, it’s the logical next step. Many people would disagree about this and I’ve had many conversations with some of the leading economists in London about this as well. It is the most logical next step for the European currency and the European Union. Nobody will talk about this ahead of things like the German elections because they’re trying to persuade the German electorate that this is the best move for them, it will not win you any additional votes. But I do think it’s the next logical conclusion: full fiscal union. This doesn’t mean it’s going to happen this year and certainly not in 2018, but I think you could possibly at the beginning of the next decade see acceleration in this. If you have Macron which we all know, an overwhelming victory in the French elections, he’s very pro-Europe. We’ve got Schultz and Merkel in Germany. I mean Schultz is obviously very much more pro-Europe. And then Renzi in Italy, again, I think you’re potentially going to, even though the likelihood for an Italian election is a hung parliament, I think ultimately it will move to more fiscal union.

Look at the alternative, you know, European Central Banks have done as much to stimulate economies, generate inflation, and it’s been very accommodative, certainly the ECB since 2013/2014. I think now it is they are trying to push the emphasis onto politicians and governments to suggest that quantitative easing will come to an end and we have to accept that that’s going to be the case – whether it be December of 2017 or into 2018, ultimately we are going to move away from this. So ultimately if the ECB or central banks are not buying an asset class, they need to find some way for somebody else to buy the asset class instead of them. And I think you generally will see more of a broad-based discussion about full blown fiscal union. And indeed you’re seeing some of the early signs of this. But I think this is certainly something to be thought about but I don’t think you’re going to see it much before 2019/2020.

PRESENTER: Well, Dicky, sadly, we’ll have to leave it there, thanks so much.

DICKY HODGES: My pleasure.