While the US economy ended 2003 far stronger than it started it, bond yields were not much above their starting levels. The reason for this is that support for US nominal bonds from non-economic buyers – mainly Asian central banks — has been a key influence.
Most purchasers of US dollars and bonds, in particular Asian central banks, are not motivated by expectations of economic gain, but rather by keeping their own currencies from appreciating. This strategy has resulted in close to half of all US Treasury bonds being held by foreigners.
Looking forward, there are a number of risks for global bond markets. These forces include:
· US dollar weakness (the bulk of the foreign capital inflows have been into bonds); and
· Fiscal indiscipline in the US means high new bond issuance.
While these risks all stem from the US, other bond markets will not be immune to any increases in US yields. An important positive for Australia is the Government’s fiscal prudence — however this may not stop our yields rising along with those in the US.
Looking forward what happens to bond markets depends on the scenario that eventuates – in particular whether inflation expectations rise or deflation risks re-emerge.
There do not seem to be any immediate risk of inflation — in fact there is still deflationary pressure (persistent strong growth from the Chinese manufacturing engine, and only very weak growth cycles in Japan and Europe)
Looking over the next few years is there risk of rising inflation? The answer to this question is that there are always risks of a variety of scenarios. Why might inflation rise?
· It could be cost driven, for example a disruption to oil supply drives prices up;
· Or the result of strong demand — we are seeing stronger growth in Japan, and policy is very stimulative in the US;
· And there is another, little discussed, source of inflation risk. Global outsourcing of manufacturing has lengthened supply chains (goods are transported from further away). And this present greater potential for disruption, which makes just-in-time stock control harder to implement. And, with demand for sea transport bursting at the seams, it is also driving up freight rates. Possible bottlenecks, supply disruptions and lower than expected costs savings from outsourcing may all be inflationary.
But it’s not only inflation expectations that are a risk. Perhaps more important is that, with cash rates very low, the Federal Reserve have made long bonds quite attractive.
A sudden rise in short rates or a burst of growth could have participants in this ‘carry’ trade (ie those chasing the higher yields of bonds versus cash) running for cover — perhaps in a not dissimilar way to 1994!
And looking forward a key question for markets is whether the Asian central banks will make sufficient purchases of bonds (particularly given increasing issuance by the US government as a result of fiscal indiscipline), to prevent yields from rising.
At some point there has to be a realignment of market yields to the fair value assessment of economic buyers. When and how this will occur remains uncertain.
The bottom line is that, looking out over the next few years, there are a range of risks facing bond markets. The question is, is this something that investors understand and are prepared for?
Managing Risks in Bond Markets
There are some important implications for investors. And the only reliable way to manage the uncertainties involved is to diversify portfolios, and to ensure that the risk involved in debt strategies is consistent with investors’ time horizons and risk tolerance.
Recent changes to MLC’s debt strategy provide important protection for investors with lower tolerance to the risks of rising bond yields. Investors at the lower risk end of the spectrum typically have the highest allocations to debt assets, and these are regarded as defensive allocations. However, debt portfolios can deliver negative returns. The use of one size fits all debt strategy’s results in significant interest rate risk in capital stable funds.
MLC now has individual debt strategies (versus the usual one-size-fits-all approach) that are designed to be consistent with the objectives of each fund. The debt component of our capital stable fund involves less interest rate risk than that of our balanced fund.
This approach provides important protection for investors with lower risk tolerance. It means that risk stance is consistent with investors needs and expectations.
Dr Gosling is Investment Manager with MLC’s Investment Management Division
