Brace position

The great rotation, the end of the bond bull run, Brexit, Donald Trump’s election and the rise of populism: during his annual trip to Australia in January, Vanguard’s New-York based global head of fixed income, Greg Davis, shared his insights on all these topics – and more – with KangaNews.

The obvious place to start is the geopolitical backdrop. Brexit and Trump seem to have reshaped the political landscape in the West. What do we know, and what do we suspect, with regard to the market impact?
What’s very clear to us as investors is that we are in an environment of greater uncertainty. Clearly Brexit was not expected. Trump’s victory was not priced into the market either.
As the climate continues to evolve we should continue to expect greater uncertainty. Given the cross-border treaties and other issues that have to be worked out in relation to Brexit, the overhang could take years to unfold.
As for the change in administration in the US, there is lots of talk but a lack of accompanying detail. This means it is unclear exactly how much will be implemented and what it might create from a fiscal standpoint. There has been rhetoric around reducing the regulatory burden, changing corporate-tax policy and introducing a significant spend on infrastructure. But how this will be paid for is all unknown.
This lack of detail means it is far too early to assess potential long-term impacts for the bond market or other asset classes.

With so many unknowns in play, can it be anything other than business as usual for portfolio management at the moment?
We are not political strategists. We believe we can add value in security selection and sector positioning. We assess economic growth in each of the regions in which we invest, and the impact our expectations might have within these respective countries, and we construct our portfolios accordingly.
What I would say is credit markets have had a good run over several years and spreads have continually tightened, to the extent that our view now is that they are starting to look slightly rich. We judge how we structure our funds based on valuations and our views on overall fundamentals. This is leading us to reduce the amount of credit risk we have in our active portfolios on the basis that valuations are not as attractive as they were.

There is talk again of the great rotation, but Vanguard’s chief investment officer recently said it’s unlikely investors will leave bonds for equities. This may not be something you want to see, but realistically how likely is it to happen and what can stop it?
After the global financial crisis investors generally better understood the importance of having diversification in portfolios – in other words the importance of having bonds.
When we were in a zero interest-rate environment in the US, many investors moved from money-market portfolios into longer-duration and credit products. As yields continued to compress they went into high-dividend-paying stocks, real estate investment trusts (REITs) and other products that at some level are bond substitutes but in reality are equities. During volatile periods people realise that high-dividend-yielding stocks and REITs behave like equities – and that if there is a significant downturn in the equity market there ought to be some exposure to high-quality bonds as a diversifier.
We therefore believe the idea of selling bonds and moving into stocks is much overplayed. When we look at our cash flows over the last year, US$300 billion came into Vanguard and US$139 billion of this was into bonds. So we are not seeing any sign whatsoever of a great rotation and nor do we expect it. The reality is if we see rates rise through normalisation of monetary policy this to some extent makes bonds more attractive than they have been over the last couple of years.

The other hot call has been the imminent end of the bond bull run. Is this call finally right?
Bonds are supposed to serve as the diversifier. We don’t look at the bond market and take a view on whether it is going to be a bullish or a bearish year. We realise that our long-term investors value bonds for their associated diversification power.
Even if we find ourselves in an environment where interest rates around the globe are significantly higher, bonds will still play a vital role in portfolio diversification. For long-term investors, the reality is that higher interest rates are good because they allow investors to reinvest at higher yields, thereby securing higher returns.

A recent Vanguard report said by late 2016 market sentiment had shifted from an overly pessimistic expectation of cyclically weak stagnation towards an overly optimistic expectation of growth acceleration, but that both were wrong. Why?
The marketplace is thinking we are going to be in a period of low growth. Our economics team’s view is that trend growth in the US is about 2 per cent, which means the prospect of a recession is on the horizon. This means they think the idea that we are in stagnation with 1 per cent growth is a story which is much overplayed. We think we are more likely to achieve trend-line growth of 2 per cent or thereabouts.
A lot of euphoria has built up in the market since Trump’s election, particularly in relation to regulatory reform and fiscal stimulus through tax and infrastructure as a way to boost economic growth.
Of course, there could be a positive shock to the economic growth picture. However, our view is that even if some of the expected fiscal stimulus could be worth 50 or 75 basis points of economic growth the euphoria is leading the market to be pricing in substantially more than this. We think this is why expectations around growth acceleration are overplayed.

European event risk is also back on the agenda for 2017 – if it ever left. How significant a risk do you believe the upcoming run of elections could be and how can a bond investor position itself for this sort of binary risk?
There is a level of uncertainty around Europe much to the same extent as there is a level of uncertainty around Brexit and Trump. Polls have been wrong of late and we are clearly in an environment of greater uncertainty.
People have also been incorrect in their expectations of market response. They assumed that if Trump was elected it would be bad for the equity market and in fact it was the opposite. With Brexit, the expectation was for an immediate decline in the British equity market and for the UK economy to fall into recession. Again, what we have seen is quite the opposite.
There is a great deal of uncertainty. Populism is growing in Europe and may further develop with many segments of the population believing they are being left behind while others are doing relatively well. I think folks are tired, which is why they are voting this way.
What this might mean for Europe and the single currency only time will tell. But the volatility associated with it is something we are going to be living with for many, many years. It is not clear to me whether the euro ‘experiment’ will unravel at some point. There is of course a possibility that it will but we’re talking about many years to figure this out.

What do you think would be the consequences for Australia of heightened uncertainty in global markets? Can it be a safe haven, especially given the potential threat of a US-China trade war – and if so how might Vanguard’s weighting to Australia change?
With a triple-A rating on its government bonds Australia is still viewed as a safe-haven currency. Historically we have seen the flight-to-quality trade in evidence when there is a downturn in the equity markets.
Last year there was a 57 per cent correlation between 10-year US Treasuries (USTs) and Australian Commonwealth government bonds (ACGBs). Australia is viewed as a safe haven when it comes to high-quality government bonds. To the extent there is uncertainty in the marketplace ACGBs – with their yield and triple-A rating – will continue to be viewed as a very attractive asset class for global investors during periods of stress.

In that case, would losing its triple-A rating potentially damage Australia’s safe-haven reputation?
Australia would still be viewed in high regard, but less so. In the search for safety and diversification, even with a double-A rating, ACGBs would continue to be viewed very highly by global investors. But the correlation to USTs would be less than what we’ve historically seen if the Australian rating starts to decline.

Vanguard’s outlook for returns in 2017 is modest compared with recent years. How is the investment strategy likely to change in this context?
The best indicator of returns on bonds is current yields. In an environment like today’s the yield on a global aggregate index is around 1.6 per cent, depending on whether an investment is hedged and, if so, on the level of the interest-rate differential between the home currency and the broader index. But purely as a proxy, this is a good indicator of expected returns over the next five or 10 years. If we are starting from a point where yields in the bond market are substantially lower than they were 5-10 years ago, one ought to expect a lower return from the asset class.
The same principle also holds true for equities. Where starting valuations are at more elevated levels and price-to-earnings is rich compared with historical levels, over the next 5-10 years it is likely that returns in the equity market, given starting conditions, are going to be slightly below average relative to historical levels.
As global managers, we believe we can add value in security selection and sector allocation. We also have a bias to add value by being long the term premium or by having slightly longer duration depending on our yield perspective.

Vanguard’s outlook for bonds and stocks remains the “most guarded” since 2006, according to one of its research reports. In this context, your advice to investors is to evaluate the role of all asset classes from a perspective of balance and diversification rather than outright return. In Australia we have seen local real money focusing more on liquidity and homogeneity, rather than diversity of issuance. How can investors balance a need for liquidity with a fully diversified portfolio?
We strongly believe in the value of having diversified portfolios because diversifying the portfolio provides greater liquidity. The reason I say this is that a diversified portfolio does not contain large, concentrated positions that can, at times, be very hard to move without significant price impact. Selling US$5 million parcels 10 times over is a much easier transaction than a single US$50 million parcel – and selling a larger chunk will almost certainly have a greater price impact.
Focusing on single, highly concentrated positions, which might be beneficial from a liquidity standpoint, can be just the opposite when it comes to having to transact.

The US credit market reopened with a robust tone in 2017. The first week of the year was the largest first week ever for bond issuance and the fourth-busiest week of all time. There’s a sense in Australia that some of this was issuers getting set before expected event-driven volatility during the year. Is there anything else driving the deal flow – and can it be sustained?
As we hit the tail end of 2016 with rates beginning to rise – 10-year USTs have risen to 2.6 per cent from 2.3 per cent – some corporate treasurers were clearly cognisant that they did not want to miss out on issuing at attractive levels. There was therefore a rush to complete transactions ahead of a substantial rise in interest rates. I think what we have seen is issuers rushing to the market to front-load transactions and ultimately reduce issuance later in the year.

Australian fund managers are said to be becoming increasingly price sensitive around primary transactions, preferring to buy internationally if offshore secondaries provide a pickup. As a global manager, how easy do you find it to get set in volume in the secondary credit market?
Due to the need for diversification borrowers often issue in several different markets, so there can be different prices in each market for effectively the same credit instrument. However, just because a bond can be slightly cheaper in one market compared with another does not mean all investors will be able to benefit – because of their individual investment guidelines.
For an Australian investor, whose investment guidelines preclude buying US dollar or euro denominated bonds, it doesn’t really matter whether or not they are cheaper.
Our investment strategy is that if we like a name we try to buy that name in the market in which it trades at the cheapest level, provided there is sufficient liquidity for us to gain exposure. Investors with the ability to do this on a global basis generally do the same thing. So investors will take advantage, whether a company is issuing in a market that is slightly cheaper in euros on a hedged basis or in US dollars on swapped-back basis.