QE should help promote growth but could have unintended consequences
Opportunities in corporate bonds are now more compelling
Potential inflation tail-risks in the medium to long term
London, 23 February 2012: Following the release of the Monetary Policy Committee meeting minutes today which revealed some members called for even more quantitative easing (QE), we ask Ian Spreadbury, portfolio manager of the Fidelity Strategic Bond Fund for his thoughts on QE, along with other issues such as inflation and the eurozone crisis.
In this Q&A, Ian explains why careful credit selection is so important in this uncertain economic environment and what opportunities he currently sees:
Was further QE necessary in the UK? QE is a highly experimental and aggressive form of monetary policy that hasn’t yet stood the test of time. So far, it has provided a huge injection of liquidity into the UK economy. This should help promote growth but could also have unintended consequences. Not only could it prove inflationary in the future but it is already causing distortions. Gilts and UK equities are now rallying simultaneously because QE is artificially lowering interest rates; unusually, it is putting downward pressure on Gilt yields and inflating risk assets, like UK equities.
It is also helping keep inefficient parts of the economy afloat – banks are a good example. It is interfering with free market forces and keeping debt at historically high levels, which is preventing the economy from resetting itself. I am worried this could damage prospects for UK economic growth in the long-term. The problem is that QE is needed to keep nominal economic growth positive as the economy begins the process of deleveraging. The MPC is in a quandary; its arsenal of monetary weapons to combat stagnating growth has been seriously depleted.
The base rate is already at an historic low of 0.5% and QE is one of the few tools left. The danger is that QE is just delaying the inevitable path that the UK economy needs to take in order to make future progress. And this is of course is to deleverage.
What are your views on inflation? Inflation has experienced quite a sharp decline in recent months. However, it does remain a tail-risk and additional QE isn’t likely to help. It is important to remember that deflation factors can quickly fade like the VAT hike falling out the equation and the mild autumn weather temporarily leading to lower gas prices and weaker winter clothing sales. On the other hand, it doesn’t take a lot to push up input prices like Iran’s proposal to close the Strait of Hormuz. My point is, as a bond investor, I am always careful when it comes to inflation.
Admittedly, inflation-linked bonds aren’t as compelling as they were six months ago when markets were pricing-in lower future inflation levels. Expectations for medium and long-term inflation have slowly increased, expressed through rising breakevens; this is the spread between nominal and real yields on government bonds. The rise in yields on inflation-linked bonds means there is less value now than before. I therefore think the opportunities in corporate bonds are now much more compelling. However, I still maintain some exposure to inflation-linked bonds.
What do you think about Moody’s placing the UK on negative watch? The UK's status as a safe haven is fragile and Moody’s announcement to put the UK on negative watch is an explicit recognition of this. The agency outlined the key risks; slower-than-expected growth, a loss of political will power to implement austerity measures, contagion from Europe in the form of higher Gilt yields and another banking crisis. I believe these are very real threats that could eventually push Gilt yields up.
How have you positioned the fund recently? During the volatility experienced in 2011, I built up a safe haven ‘bucket’ to protect the fund; it consisted of cash, government debt, supranationals and inflation-linked bonds. I am now reducing that ‘bucket’ as the risk of financial contagion, although real, has declined in recent months.
I see the risk-return profile for Gilts as asymmetric – the risk of losses from higher Gilt yields outweighs the gains from what I see as limited potential for a further fall in yields. In October, I reduced duration in my funds to protect against this asymmetric risk. The position may not payoff immediately, and indeed the market reaction to the Moody’s news has been muted, but there are better opportunities to add value in corporate bonds at the moment. My focus has been on defensive stocks such as those found in the consumer staples and utilities sectors as well as covered bank bonds.
Although the growth outlook for the UK isn’t great, corporate fundamentals are still generally strong and defaults rates are low by historic standards. Additionally, low interest rates are pushing investors down the credit scale, which offers a degree of support for the corporate bond market.
Elsewhere, I have taken profits from UK and Japanese inflation-linked bonds. Inflation-linked bonds have rallied quite strongly recently, and I am seeing better opportunities in credit. Nonetheless, I still maintain some exposure to inflation-linked bonds in markets that offer better value, such as US TIPS, because the tail-risk of inflation still exists.
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