Fixed Income

When the opportunity recently came up to sit down with Charlie Jamieson from Jamieson Coote Bonds for a one on one interview, I jumped at it. He always has a strong view, and I consistently walk away having learned something interesting. And with financial markets apparently torn between two conflicting stories as both the equities and bonds rally to new heights, now seemed like an opportune moment to get his point of view on what’s happening in the world’s markets and economies.

In this Q&A, Charlie shares his current views on the global economy and interest rates, explains what the unusual interest rate differential between the US and Australia means for our economy and currency, and he explains why negative yielding Eurobonds might not be as crazy as they sound, depending on who’s buying them.

Equity markets are at all-time highs. Labour markets are either at or pretty close to full employment. So why are central banks talking about cutting rates?

Central banks around the globe are looking to cut interest rates to support not only economies, but also support risk markets. We've seen a huge slowing in global macro data and global trade over the course of 2018 and a rapid decline into 2019.

We've now got the ongoing trade war, which is obviously hurting sentiment, restricting capex, and these types of things. Pretty much across the developed markets sphere we're seeing accommodation by central banks. We're expecting 12 global interest rate cuts in the next two months, and very importantly, the Federal Reserve will be cutting interest rates on the 31st of July almost certainly. That's really important.

It's the first rate cut in in more than 12 years, and it lines up eerily actually with 2007, when they started cutting at the end of the year. US equity markets made all-time highs for that cycle in November of 2007.

There are some scary parallels, but clearly that accommodation is deemed to be needed right around the globe, and we've gone very quickly from talking about rate hikes, to rate cuts, in almost every developed market that we look at.

You were one of the first people who were calling lower rates and lower inflation. That's played out very quickly, a lot faster than most people expected. Have expectations for inflation and interest rates come down far enough? Or are they still too high?

Our call on inflation was something that we've written about all the way back through 2016, 2017. About these secular disinflationary forces in the world, that was going to make it very difficult to get this runaway inflation like we've had in previous cycles. That's broadly been proven now. Interest rates are still on their journey to resetting lower. We've been raising them in the United States since 2015. Although the majority of that happened in 2017, 2018 and now already we're going to be cutting interest rates in the middle of 2019. We feel that that's still got quite a bit of runway to complete on.

We need to think through what type of cutting cycle might this be. If it's a cutting cycle like a 1987, 1995, 1998, they were insurance rate cutting cycles where we didn't have an economic recession thereafter and asset markets kept on keeping on. But if it's something darker, like a 2000 or a 2007, a 1989, then we're going to need material interest rate cuts. In those cycles we've needed 300 to 500 basis points of interest rate cuts, now we're starting with only 250 available. The insurance rate cutting cycles have historically been 75 to a hundred if we needed to use more it's been 300 plus, and so there's a lot of discussion in the market currently about what kind of rate cutting cycle will this become.

If it is that insurance cutting cycle, then it's probably pretty good for risk markets. We've written a lot about that over the course of this year about the huge dispersion in risk market performance. The irony being that the worst the data and the macro environment has been, if that central bank safety net is under the market and that accommodation is expected, then a lot of risk markets really love that, and we're seeing equities have a fantastic year as a result.

But if there's a darker side to the cycle and that really is led by the credit cycle, then we could be looking at something more akin to, not as severe as 2008 we don't think, but certainly darker and deeper and there could be some capital destruction, which we haven't really seen for a good period. We've had little flirtations with it like Q4 of 2018, where people got a stark reminder of what is actually behind that curtain, without this constant volatility suppression and accommodation from central banks.

What will be the best early indicators of which one of those two courses is playing out, and to the best of your ability, what would you say is the more likely outcome at this stage?

It's a really difficult call at this stage. There is some delinquency starting to rise in parts of the credit complex that we monitor and that's something that we need to see. It's not something that 25 basis points or 50 basis points is going to fully redress. The build-up of those right hiking cycles takes a very long time. If we think back to the last cycle, the Fed, we're hiking from June, 2004 to June, 2006. But it's those rate hikes that accumulate that cause a big asymmetric problem in 2008. We've really only gone through that hiking cycle in full in 2017 and 18 but we're starting to say some of those delinquencies just lift a little bit.

Now there's nothing hugely worrying there yet, but they are very big supertankers of performance to turn and the deterioration is noted. Now if that starts to accelerate, we would certainly have a lot of cause for concern. There is an enormous amount of corporate credit debt that needs to be rolled forward and re-issued, as we look into 2020, 2021. Clearly if there's a loss of confidence we can see that market jam up very, very quickly, as we saw in the late part of 2018.

In global bond markets, three, three and a half times the size of global equity markets, we did not issue a single high yield security in December 2018. The markets were simply closed. For those that need to roll forward, (that really is the oil of the financial system, for corporates to be able to continuously borrow) they're not always borrowing with the idea of repaying in full, in two- or three-years’ time. Then they need to be able to access that refinancing mechanism and that is a cause for concern given some of the structural weaknesses that are in the corporate credit market as we see it.

Are there any other consensus trades out there at the moment where you think the market might have it wrong?

The hunt for yield in a low interest rate environment can be very tempting. There is a lot of illiquid or lower credit quality on offer. As long as investors really understand the risks and the liquidity implications of some of those offerings, then that's fine. But I think it's really important that there is seen to be some complacency around some of those liquidity profiles. We've already seen a number of credit funds internationally be gated and frozen, and that's happened well ahead of any material problem in the broader complex. I guess it's eerily a little bit like Bear Stearns ahead of the major event in 2008. That's probably too pessimistic at this point, but there are those worrying warning signals for investors.

It really is very important that investors understand deeply what they're investing in, understand the risks and the liquidity profiles of those offerings, and not just look at observable headline yield and think, "Well this'll do me for now, because my alternatives are clearly very, very low." It's a period where return of capital can be as important as return on capital, and it really is something that investors need to think through.

They say that equity markets run on greed, well credit markets run on fear.

And when we see this asymmetry in some of those markets, we can see very violent price declines. Not always justified, I might add, but it is something that we don't want investors, particularly who are looking for a defend and protect type allocation, to have to experience material haircuts or vast lock up periods where they don't have access to that money when they really need it.

If rates do fall further from here, that would generally imply a positive for risk assets. So does that mean you're less bearish on risk assets given the view towards lower rates?

We're not always bearish. As a bond manager we did talk about the risks and try to help people build diversified portfolios. But with regard to that secular rotation that we're talking about, if interest rates do remain low or lower for a long period of time without any problem in the credit markets, then absolutely we're going to get a secular re-rating. I think there's been a lot of equity managers that have turned on this, and I applaud them for that. It's not a surprise to me.

There are a lot of value managers in the active management graveyard right now. A lot of those guys that seemingly want to talk ad nauseum about where interest rates are going. They simply just don't look like they spend 60 or 70 hours a week thinking about interest rates, given that their profiles look very different to us. I'm not surprised that this has caught them, and they've been underinvested.

So yes, absolutely, if things can keep on keeping on, and that insurance cut cycle works, then there's no reason why they can't continue to re-rate. We do also have to acknowledge that a lot of investors are using the really high quality, defensive allocations as a barbell type approach just in case we do go down that darker road where there is a credit problem, or there is some unknown consequence out of this trade war. If there's a geopolitical problem in the Middle East as we're seeing some tension there. If there's a big Californian earthquake, or a Tokyo earthquake, or any of these things that could come out of the unknown.

In terms of that kind of broader portfolio construction, I think there's still an argument for that broad diversification to help ride all potential possibilities.

Right across the board at the moment, Australian rates, both long-term short term, are significantly lower than US rates. This appears to be an anomaly to me. I've not seen it in any time that I can remember. You've got a better understanding of financial history than I do, so has this ever happened before, and what are some of the implications of this situation?

You're right, this is pretty unparalleled times in terms of the yield differentials. We’re very excited by the US treasury market at this point. There are much higher yields on offer and potentially a runway of rate cuts that could be 10 rate cuts long, starting from two and a half percent, if we are to go back towards zero as some people have predicted.

Having said that, we must think through the foreign currency implications of investing in those markets, because there are added incomes that are provided or subtracted with the foreign hedging costs. But we do really like the capital appreciation story in the US treasury market. We think it makes a lot of sense.

The Federal Reserve has turned on a dime over the course of this year, and they're not a central bank that historically has meddled with one cut and then stop. When they do provide that insurance, they've tended to provide, as I said, 75 to 100 basis points. So we'd be thinking three or four interest rate cuts.

There's still quite a story here to play out. But we are seeing a lot of domestic investors looking at those offshore markets now where there are other stories, and alternatives and good investment themes to invest in.

What do you think it means for the currency? Could that place pressure on the Australian dollar?

Yeah, certainly. We've always written that the next move from the RBA would be rate cuts and that was very unpopular in previous episodes. St the start of 2018 we were ridiculed for that a little bit. Well here we are, and we've had 50 basis points of rate cuts now. We thought that those initial rate cuts would come because of the domestic economy required them.

I think we'll go through a period of pause and assess, which is pretty normal. But the next piece will come from a global environment that will be moving to lower rates, and in order to not see material currency appreciation, we do think that the RBA will be dragged back in. I think that’s in line with the market's broad expectation.

There's been discussions about Australian Quantitative Easing (QE) and whether it's needed, whether it's warranted. It certainly would be very effective, and you wouldn't need to do an awful lot of it to push the currency materially lower. That would be a really good thing for Australia if we can get that currency down and keep it down, Australia can grow its way out of all of its issues that we face presently.

We don't expect the RBA to cut below, say 50 basis points and they've made good comment around that. They still need to attract international capital to help fund the domestic banking system and the like. But there is a very obvious QE programme here, which would be very effective without needing to really use a huge amount of ammunition to achieve that. We think in time we're very likely to see something like that.

Do you think Australia is going down the same path as Japan and Europe with low inflation, low growth and apparently locked in for the foreseeable future?

There's no question that we're going to a lower interest rate, lower inflationary period, but we're not going to have a Japan or a European styled outcome in Australia. We're not going to a period of Japanification where there's been bad to zero structural reform and bad demographics.

Australia is a much more exciting story than that. We are, however, transitioning into this much lower interest rate and inflation environment and it's changing the way that the markets are performing. We've still got to go through that, and markets are transitioning through that. I think a lot of people are struggling with that change, but it's a change which looks very natural to us.

But the outlook for Australia is far more positive than it is for the European economies or the Japanese economy.

One last question for you. Germany recently issued a zero coupon, 10-year bond with a face value of $102.64. Meanwhile, within a few weeks of this, Austria issued a one-hundred-year bond with a yield of 1.09%. Is there any rational justification for paying prices like these for bonds?

Unfortunately there is, and the optics of the maths doesn't necessarily make sense, but in both instances, not only have those securities made a tremendous amount of money this year, that Austrian hundred year bond that you talk of, I think year to date its return is 39%, annualizing at some extraordinary rate, and those German bonds are rallying and performing very well in expectation of the ECB taking interest rates more negative than they already are.

At an optical level it looks very low and hard to rationalise, but then if we think through that in terms of FX hedged, those instruments are actually very cheap on a global basis. If you're a US investor, for instance, those German bonds are actually quite yieldy, much more yieldy than the US treasury market, because of the exchange of currencies and the promise to repay each other’s interest bills. If you've got one currency which has a negative interest rate, essentially there is a double interest payment, you pay me twice. This is something that we use with great effect in our own global funds here, but it's something that requires a little bit more thought than the natural optics that you see of negative yielding debt.

One of the reasons that Australian QE could be incredibly effective, is if interest rates at the RBA stay at 50 basis points, and there's a solid expectation that they remain there. Whilst Europe goes to a negative 50 let's say, you could issue Australian dollars, swap them to euros, and you automatically have roughly a 1% income by just making that currency exchange. So if you can then go off and buy assets that have a zero yield, where you have a constant portfolio with a 1% maturity, with a 1% expected income return.

In using QE, you wouldn't need to use a lot of it to get big effects. Because you'd be printing the currency, you'd push the currency down very quickly, whilst you make money on the entire programme over time. That looks like a pretty good outcome to us.

There are a lot of different ways that this FX hedging can intertwine with the way that the assets are actually going to perform. It's important to acknowledge that surely if you're in Germany buying German bonds with a negative yield, that is a very sub-optimal outcome. But for a lot of other investors around the world, particularly Japanese, US, they're actually pretty yieldy assets. Now we're not talking about yield in the context of yield in the 1980s or the 1990s, but in a world where we have incredibly low cash rates, well it’s a relative thing, isn't it?

So yes, there is economic rationality to owning those assets. Those assets have made a lot of money over the course of this year, and if the ECB continued to cut, as many other central banks will continue to cut, they'll continue to make money for some time yet.

Avoid getting caught in the trap

As we continue to face volatile market periods, bonds will offer the stability of principal and income, as investors seek the highest quality investments. Click contact below to find out more or visit Jamieson Coote Bonds website for further information.



Comments

Please sign in to comment on this wire.

darren franklin

Patrick are you able to get Charlie to put down a working example of how these guys make money on negative yielding bonds through the FX swap - fascinating.Regards Darren