Long-term investors can sidestep the impact of short-lived news flow and steer portfolios through this shift in monetary policy
Global central banks, led by the US Federal Reserve, have taken the initial steps along the path of monetary policy normalisation by scaling back quantitative easing programmes and raising base interest rates.
As the period in which policymakers have held sway over markets draws to a close, the characteristic low levels of volatility that some may have grown accustomed to will be at an end. Episodes of global market turbulence, such as we saw in February, could become more frequent going forward.
Swings in sentiment, influenced by the 24-hour news cycle and the advent of social media, are also bound to impinge even more on what are now skittish credit markets, adding to the challenge of balancing yield generation with capital preservation.
By focusing on the bigger picture, however, long-term investors can sidestep the impact of short-lived news flow on the markets and steer portfolios through this fundamental shift in monetary policy.
A tidal wave of information
The enormous amount of data available to investors has been a defining characteristic of the current cycle. More real-time information is being consumed by a market that is arguably less liquid. Whether it is central bank forward guidance or geo-political news flow being assessed for implications on monetary policy, it is undeniable that the market reactions have become quicker. This also makes them more prone to overreaction, because they are less able to effectively filter out initial noise.
This phenomenon was apparent in February, when a small uptick in US wage inflation led to widespread fears that the Federal Reserve would hike interest rates more aggressively. A shockwave of stock market volatility then reverberated through global markets, leading to a dramatic sell-off in risk assets such as credit.
Similarly, in the immediate aftermath of weak UK Consumer Price Inflation data in April, the 10-year gilt yield fell by 7bps, before closing down just 3bps. The fact that yields rose well beyond the pre-CPI release levels in the days that followed shows some tacit agreement to the view that raising the base rate was a matter of when, not if. This instance particularly highlights the danger of participating in market moves driven by short-term sentiment.
Assessing rates rationally
Instead of attempting to forecast the precise timing of each interest rate movement, we believe investors should look at the bigger picture. Quantitative tightening is set to continue occurring across developed markets, with the European Central Bank ending its bond purchases in 2018. As long-term investors, we can focus on the direction of rates rather than each and every data point or item of market news, and use this view as the foundation for our portfolio positioning.
Our outlook is an expectation of steady interest rate rises, with further rises in credit spreads being a distinct possibility. In a market that is increasingly susceptible to knee-jerk reactions, separating noise from genuine market inflection points is of the utmost importance. Turning points will prompt a justified reaction and a consequent re-assessment of our strategy, whereas speculation should remain just that.
While the market dislocations created by news flow can be problematic for fixed income investors, they can also create opportunity. For instance, we took advantage of the February spike in credit spreads to pick up good quality subordinated debt with early call options at attractive yields, in-line with our goal of keeping portfolio duration low.
Real risks on the horizon
Although it is important to put headlines in context, there are still risks on the horizon for markets. Geo-politics, as seen with the US trade tariffs, uncertainty in Europe and ongoing Brexit developments, all pose risks.
At the same time market dynamics, after years of unprecedented policy easing, have been fundamentally altered. Central banks now have less room to manoeuvre at a time when investment banks have been regulated into playing a less active role in facilitating market activity. This amplifies the market’s reactions to events and or data.
As much as we do not believe a recession is imminent, episodes of market volatility are likely to occur with increasing frequency. We also continue to seek out tactical opportunities to add quality higher yielding assets. Fortunately, headline-driven market dislocations, in which reactions are divorced from the underlying picture, avail attractive long-term entry points to execute this strategy.
David Katimbo-Mugwanya, co-manager of the Amity Sterling Bond fund at EdenTree Investment Management