Talk to the majority of fixed income managers today or read their fund commentaries and you could be forgiven for thinking the world is entering a golden economic era.
To some extent, this optimism is based on bond prices continuing to rally from the depressed levels of the immediate post-Lehman era. But a few investment houses, including Old Mutual Asset Managers, are having none of it.
OMAM, which manages £3.5bn (€4bn, $5.7bn) in assets and is known principally for its equities and hedge fund capabilities, has recently stated its intention to become a big name in bonds with the appointment of Stewart Cowley as head of fixed income.
Mr Cowley, one of just three triple A-rated bond managers in the world, thinks widespread hopes are misplaced. “Corporate bond yields are back down to where they were eight or nine months ago, which may not be sustainable. We are going to see high default rates and spreads could widen sharply on high yield in particular,” he says.
How seriously ought investors to take these decidedly non-consensus views? Certainly, OMAM values them extremely highly, having poached Mr Cowley this year from rival Newton Investment Management, where he oversaw nearly £6bn in assets. Under his leadership, assets in Newton’s two flagship fixed income funds rose 30-fold from about £200m in just six years.
He is tasked with repeating the trick at OMAM. This may be possible if he can maintain the forecasting powers that saw him predict both the US housing market downturn and the demise of the leveraged consumer market.
In 2005, he developed a model to assess the resilience of a typical family – with average credit card debts and mortgage – to rising interest rates. The research revealed that their disposable income would disappear when central bank interest rates reached 5.25-5.5 per cent. At this point, Mr Cowley says, “the whole thing tips over”. The US raised rates to 5.25 per cent in June 2006 and the UK followed suit in January 2007. Just a few months later, the whole thing did indeed “tip over”.
He predicts that the world economy is close to another “violent” inflexion point that will make fools of those forecasting green shoots. “The budget expansions we have seen around the world are just about holding things up – but it isn’t hard to make a case for another sharp leg downwards,” says Mr Cowley. He believes the impact of the downturn on the real economy is only now starting to be felt. As unemployment rises, bad debts will skyrocket, leading to a rush of corporate defaults and new bailouts of banks. The situation will deteriorate further as creditor nations, such as China and Middle Eastern countries, refuse to increase the rate at which they buy US Treasuries – an increase that is necessary if the US is to service rising future obligations.
China and other countries have already indicated they wish to move from a dollar-based reserve currency system to a broader-based mechanism.
Many observers are sceptical, but Mr Cowley sees a number of triggers that could speed such change. “A decisive moment came earlier this year when S&P put US debt on review for downgrading,” he says. “I think we are also close to the point when creditor countries stop lending to merchants and start lending to their own consumers. I can’t understand why everyone is running to the dollar, which is the focal point for all the problems. The endgame for the dollar is likely to come in the next couple of years.”
For the moment, however, Mr Cowley is long government debt, which he expects to outperform as asset values fall and interest rates remain at rock bottom. Over-allocating to corporate credit is to be avoided as the higher cost of funding for companies will push more of them into bankruptcy. A handful of banks, however, represent good fixed income opportunities as they rebuild their balance sheets.
Mr Cowley is also bullish on the bonds of technology, telecommunications and pharmaceuticals companies. In the longer run, government bonds and dollar-denominated assets are off the OMAM radar. “After a period of very low bond yields, quantitative easing and other expansionary strategies that lead to the debasement of currencies will create high bond yields and high inflation,” says Mr Cowley. Of course, long-term strategies are hard to time and risk the wrath of investors if they are slow to reach fruition.
“The markets can sometimes give you a kicking if you take too high level an approach,” says Mr Cowley. His answer is to use instruments that place a long-term bet without committing too much of the fund’s capital. Mr Cowley’s conviction that US housing was heading for a fall, for example, was backed by a call option on US long-bond yields in June 2006.
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