“Western economies are bust and, well, that’s the good news.”
So began Jim Leaviss, Head of Retail Fixed Interest at M&G Investments and creator of their famous BondVigilantes blog. Jim was chatting with David Stevenson at one of Portfolio Review Online's events. David also runs the Financial Times’ ‘Adventurous Investor’ column.
After describing how western economies had bankrupt themselves by borrowing from future growth, based on a model of leverage and over-consumption, David and Jim went on to talk about bond market opportunities and the infamous Eurozone problems. Here are a few of the key takeaways:
– Governments unlikely to be able to inflate away all their debt (this time)
The high inflation period following the Second World War reduced the debt burden on governments by reducing the value of debt to be repaid. In 1981 the UK issued its first index-linked gilt (ILG), with both interest payments and repayment of principal rising with inflation. With ILG’s making up a quarter of the UK government’s outstanding debt (DMO data), the value of UK PLC’s liabilities (debt) will increase in line with rising inflation – certainly a consideration for the Debt Management Office in deciding whether to issue RPI/CPI linked gilts.
– There’s enough cash to solve this crisis
Japan has managed to survive a prolonged deflation and stagnant economy due to the vast amount of savings held by its citizens, both in Japan and abroad. Countries like Italy also have enough cash to survive the crisis, it’s just that those holding the cash are not willing to lend it to their government – unless yields rise and investors are compensated for the extra risk. Getting some of that idle cash into productive investments is key to improving the economy.
– Be aware of X-Factors not currently in market prices
The efficient markets hypothesis suggests that all publicly known information is reflected in an asset’s current price. It’s what is not priced that investors should be careful of. Examples cited were the US Federal Reserve potentially shifting priority from controlling inflation to boosting growth and gilt prices continuing to rise should the Bank Of England continue to purchase assets/ease quantitatively – UK yields reaching Japanese levels not impossible in current macro environment.
– Index-linked versus nominal bonds
When is an investor better off owning bonds linked to inflation versus those with no linkage? Jim suggested owning index-linked bonds when current Retail Price Index (RPI) is higher than breakeven inflation (BEI) and, conversely, preferring nominal bonds when RPI<BEI. This makes sense but investors would still need an accurate prediction of RPI and BEI before re-allocating any of their portfolio – as cental banks have seen, inflation is a tough beast to control or forecast!
– European resolution
Only an undemocratic entity, like the European Central Bank (ECB), is able to produce the monetary firepower required to solve the Eurozone crisis. They could, for example, set a specific target for government bond yields whilst promising to purchase bonds should any bond market vigilantes demand higher yields to hold the debt. The question remains whether the ECB will receive/accept/act upon this mandate before more troubled Eurozone countries go the way of the Greek debt-dodo.
David’s events always bring up some interesting thoughts/ideas and the BondVigilantes financial blog is one of the best out there – you can find out more here: