Podcast: Bond market panic - how might investors respond?

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[00:00:07.930] - David Brett

Welcome to The Investor Download, the podcast about the themes driving markets and the economy now and in the future. I'm your host, David Brett. If you believe to the press, something is brewing in the markets.

[00:00:29.370] - News clips

We're in the middle of what some are calling a historic time in the history of US government. Bond pricing yields have risen to highs not seen since 2007.

[00:00:39.250] - News Clips

The panic attack, is it here? Is this the panic attack? This is clearly a panic attack. Whether there is more to come or not, it's not clear.

[00:00:50.580] - David Brett

Bond yields have risen on concerns that central banks in developed markets are not yet done with their interest rate hikes.

[00:00:58.150] - News Clips

Uncertainty still remains over what the Fed's next move might be in its fight against inflation.

[00:01:03.150] - News clips

The market discourse now is the Fed's done or close to done? And my message to investors is that the market is not done.

[00:01:11.480] - David Brett

That sent bond yields to levels not reached in decades and spawned some dire headlines in the press, some of which are warning of a 1987 style crash in financial markets. Concerns of an imminent pullback in markets have prompted some nervous investors to take defensive action.

[00:01:31.830] - Alex Funk

It's buying protection in the portfolio for what is the eventual effect of five under basis points of rate hikes and what that could have done to pass to the financial system.

[00:01:39.970] - David Brett

That's Alex Funk, chief investment officer of Schroder Investment Solutions. In this show we'll look at what's spooking investors, how concerned they should be and where might be best to invest in these uncertain times.

[00:01:59.270] - Announcer

On Apple podcasts, Spotify or wherever you get your podcasts. You're listening to the Investor download.

[00:02:06.310] - David Brett

So why is the bond market so important? Well, because it's huge, worth nearly $130 trillion according to the securities Industry and Financial Markets Association. And bonds are basically IOUs. Investors purchase a bond which is effectively a loan to a business or government. In return, the lender is paid interest or otherwise known as a coupon for that loan, with the promise to repay the loan in full at the end of an agreed period. If interest rates on bonds rise or their prices fall, it usually indicates there's something not quite right. Either investors are losing faith in the borrower's ability to pay back the money, or interest rates in the real economy are about to rise. Sometimes it's both, but either way it could be a sign of trouble ahead.

[00:02:57.450] - Alex Funk

In this case, it's slightly different in the way that the market's not necessarily saying you're going to go much higher, but rather saying you're going to stay higher for longer and I think that's an important adjustment and so the bond markets had to reprice for that.

[00:03:11.920] - David Brett

That's Alex funk again. He's specifically referring to interest rates in the US, the UK and potentially Europe staying higher for longer than expected or potentially even rising further from their current levels. That can affect the yields on government bonds known as GILTS in the UK or T bills or treasury bills in the US, for instance. Yields can creep higher if investors expect interest rates to rise. That's because they can get better rates on newer bonds, which renders older bonds on lower rates less valuable. We saw that in 2022, when inflation that was supposed to be brief and acute ended up being longer lasting and more painful.

[00:03:54.290] - News clips

Well, inflation in the United States is again surging to the highest level in 40 years.

[00:03:59.440] - News clips

Inflation in the United Kingdom has surged to a new 40 year high and is now in double digits.

[00:04:05.490] - News clips

The European Central Bank has raised interest rates ss inflation continues to weigh on the eurozone economy.

[00:04:11.430] - David Brett

It forced central banks to raise interest rates harder and faster than anyone expected.

[00:04:17.470] - Alex Funk

And so if we think about what happened in 2022, there was higher interest rates because there was really high inflation, and central banks had sort of given up on this idea of transitory inflation. And then summer happened, right? And it's almost like this episode of I Know What You Did Last Summer.

[00:04:33.230] - News clips

What are you waiting, huh? What are you waiting for?

[00:04:39.670] - Alex Funk

Because we had a similar awakening last year where the markets realised the Fed was going to go a little bit higher. In this case, it's slightly different in the way that the market's not necessarily saying you're going to go much higher, but rather saying you're going to stay higher for longer. And I think that's an important adjustment. And so the bond markets had to reprice for that.

[00:04:59.760] - David Brett

Why they might stay higher for longer. That's coming up.

[00:05:03.400] - Announcer

Get in touch with us by email at schroderspodcasts@schroders.com or visit our website, schroders.com/theinvestordownload.

[00:05:14.310] - David Brett

A number of worries remain for investors and policymakers. So far, economies to a certain extent have been somewhat immune to the record number of rate hikes. Interest rates in the US and the UK, for instance, have gone from near zero to around 5% in around twelve months. Yet job markets remain relatively strong and wage growth, particularly in the US and the UK, is outpacing inflation. Add to that geopolitical tensions heightened by the war in Israel.

[00:05:45.140] - News clips

We start in the Middle East, where security forces in southern Israel have moved to a war footing to combat a surprise attack by the Palestinian militant group Hamas

[00:05:56.270] - David Brett

And suddenly focus returns to supply chains and energy costs. And you have a potent mix affecting interest rate expectations. And perhaps crucially, a belief is starting to set in that central banks will no longer come to the rescue by cutting rates or flood the financial system with cheap money to drive down borrowing costs. That's all being reflected in financial markets.

[00:06:20.750] - Alex Funk

And so we see these bond yields moving up. We can see what we call sort of term premium in the market moving up.

[00:06:26.520] - David Brett

In the US, the 30 year treasury bond rose towards 5% for the first time since 2007, while their prices have plunged. In the UK, the yield on 30 year GILTS rose above 5%, its highest since 1998. What does that mean in real terms? Well, for every one percentage point rise in GILT yields, the UK Chancellor needs to find 26 billion pounds more to meet the Government's five year interest rate payments. That's a lot of money to find for cash-strapped governments.

[00:06:57.580] - Alex Funk

So what is that extra bit of yield I need for holding bonds over longer periods of time and really assume that risk within my portfolio. And so investors are saying I need to be paid more for this.

[00:07:08.540] - David Brett

When bond markets come under pressure, investors usually turn to stock markets, which tend to head in the opposite direction. However, and unfortunately for investors, as bond prices have fallen, so too have stocks. America's S&P 500 is down about 8% since the end of July, and the UK's FTSE 100 is down just over 7% since February.

[00:07:32.290] - Alex Funk

And so, all of a sudden, higher financing costs makes investors and equity nervous, right, because all of a sudden it costs companies more to borrow money to grow. That will affect their margins.

[00:07:42.940] - David Brett

Just like homeowners who have to renegotiate their mortgages at interest rates potentially higher than they have been over the last 15 years, businesses too face the pain of paying significantly higher rates on their borrowing when their deals come up for renewal over the next few years.

[00:07:58.760] - Alex Funk

They're worried about how that affects the consumer, who ultimately buys their products or services. And so you get this risk off movement. And all of a sudden the correlation between equities and bonds go to one and they sell off at the same time. So we could touch a little bit about geopolitics in a minute, but I think thinking about what the real risk is for investors is inflation reemerging.

[00:08:19.060] - David Brett

While inflation is still falling, it still remains well above Central Bank's target of 2% and there are concerns it could rise again.

[00:08:28.200] - News clips

Perhaps even more importantly, the Fed left the door open today for future interest rate hikes. They're just not sure they have fully tackled inflation just yet.

[00:08:37.860] - Alex Funk

So wage growth is greater than inflation in the US and so there is a risk that that incremental, let's call it excess income that they're making at this point relative to inflation is then used to spend more and that then really reignites some concerns around inflation. Now, throw in the geopolitics and clearly the risk of what we're seeing happening in Israel right now is a broader contagion across the Middle East as the effects on the oil price. Right, we've already seen a movement up in the oil price in the last couple of months. It's normalised a little bit, but again, this, I think, reignites some of that risk.

[00:09:10.260] - David Brett

Oil prices, which have surged around 30% since June, are now closing in on $100 a barrel.

[00:09:17.030] - Alex Funk

Oil doesn't pass through one to one, but it does come through in aeroplane tickets and so on and so forth, the cost of producing goods and services but that pass through is not one to one. So you won't see the immediate reaction in the same way. But that is the clear headache, that is the clear risk. And that is the reference back to the 1970s where inflation comes off and then all of a sudden reignites. And then you're seeing central banks go from 5% rates to 6% rates and the market is definitely not priced for that. And that, I think, is a risk to investors.

[00:09:46.630] - David Brett

What markets also don't seem to be pricing in anymore is the risk of a recession.

[00:09:52.130] - Alex Funk

Let's be honest, markets don't like things they don't expect, right? And currently bond yields, equity prices, it's priced in for a soft landing, right? It is priced in for this idea that inflation continues to move down, unemployment doesn't move rapidly up. Yes, there is a slowdown in earnings, but the US doesn't go into this deep, dark recession and the next part of the cycle continues. The upset to that is re emergence of inflation, further restrictive monetary policy alongside quantitative tightening. And that's not really in the markets today. And I think the unexpected is what's causing nervousness, concerns, volatility at any point in time.

[00:10:30.240] - David Brett

What that means for where you might want to put your money, that's coming up next.

[00:10:39.870] - David Brett

Where inflation and interest rates go from this point is anyone's guess. And Funk says that the situation in Israel will give policymakers food for thought if they were thinking of raising rates again before the end of the year. But that's by no means a given.

[00:10:56.000] - Alex Funk

Yeah, so we think we're in this transition period from hiking rates to pausing rates to cutting rates. And I think so from a value growth perspective, there's no real view as to which would outperform in the near term, right? Because we're sort of moving between these cycles. That said, volatility creates opportunity, right? We're definitely hearing from underlying fund managers, we're buying in that getting more excited about bond yields at these levels. And we know that from the point that central banks pause and then cut, that there is significant benefit and capital gain to be made within the fixed income market. The question is when is that? Right? So we'll see a little bit more information, I think of the reaction in November as know, does the Fed hike again or do they press the pause button? And I think what's happened in Israel is definitely weighing on that decision. But then, again, we spoke about this a few quarters ago where bonds were interesting and yet bond yields moved against us yet again. So I think being prudent in diversification and how we manage that portfolio is important.

[00:11:54.290] - David Brett

Funk says emerging markets could be part of that consideration. Emerging markets were ahead of the curve in raising interest rates to help control inflation and they're starting to cut the rates now even when developed markets might be considering more hikes, but that may also mean emerging markets dealing with a potentially stronger dollar, which will make things tougher for countries exposed to dollar denominated debt. The stronger the dollar, the more expensive it is to repay that debt.

[00:12:21.700] - Alex Funk

Right? So as the dollar gets stronger, that creates some challenges for emerging markets. But on a strategic basis, they're hikes first. We would expect some cutting to happen first, which we're seeing some. So there's some opportunities there.

[00:12:32.360] - David Brett

And as for equities, Japan remains a star after actions taken by policymakers this year to make companies more competitive. Also, in a country that has been in structural deflation for so long, inflation is good for business, particularly for those that can pass on costs to consumers. But in general, when it comes to equities, Funk urges investors to look for quality assets.

[00:12:57.920] - Alex Funk

So the governance shift in the Tokyo Stock Exchange, asking companies to up their price, to book value, to make it a more competitive landscape, make it more investable, that's really attractive. Tie that together with the fact that you've got a little bit of inflation. So a country that's been in structural deflation all of a sudden has a bit of inflation. You've got to remember, equities like a little bit of inflation, right? Because I pass that cost on to you, you pay a bit more, hopefully I make some more money because I can control my input costs. This is looking exciting, right? So I think that's great from Japan. Then, from an equity perspective, we still prefer quality assets, right? So we prefer quality equity as much as we can. These are strong balance sheet companies, consistent revenue, consistent cash flow as brands that consumers tend to buy through the cycle. And so if we do go through the slowdown, I mean, you have to believe that 500 basis points of rate hikes eventually bite in some shape or form. The question is, how much does it bite?

[00:13:52.150] - David Brett

And that potential bite could mean investors taking a significantly defensive stance.

[00:13:57.600] - Alex Funk

It's buying protection in the portfolio for what is the eventual effect of 500 basis points of rate hikes and what that could have done to parts of the financial system. So SVB in the beginning of the year was almost that event, I think, for parts of the market, given the excessive rate hikes.

[00:14:12.680] - News Clips

A rough week for the banking industry.

[00:14:14.650] - News clips

The collapse of Silicon Valley Bank.

[00:14:16.630] - News Clips

The second biggest bank collapse in US history.

[00:14:18.870] - Alex Funk

So we don't know if there's another SVB or SVB like in the system. And so we still prefer what we sort of term risk diversifiers, things that will be uncorrelated to equities and bonds during periods of stress. It's buying protection in the portfolio for what is the eventual effect of 500 basis points of rate hikes and what that could have done to part of the financial system. And so we know over really long periods of time that equity is the only asset class that gives you real returns, right? And so investing in cash almost always gives you negative real returns, right? Clearly the time period is uncertain of that, but there's this risk of trying to time the market by being in cash versus in equity. So we prefer to take a strategic approach, spending time in the market rather than timing the market. We know over long periods of time, equities tend to go up.

[00:15:09.890] - David Brett

Well, that was the show. We very much hope you enjoyed it. If you want to find out more, please head to Schroders.com/insights and we're endeavouring to record as many of these shows in the studio, on video. And if you want to watch them in their full, unabridged version, then go to Schroder's YouTube channel. If you want to get in touch with us, it's Schroderspodcasts@schroders.com. And remember, you can listen, subscribe and review the Investor Download wherever you get your podcasts. New shows drop every Thursday at 05:00 p.m. UK time. But above all, keep safe and go well. Cheers.

[00:15:46.250] - Announcer

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