17th March 2016
M&G Optimal Income's lead manager Richard Woolnough on key issues and world growth
Richard discusses some of the key issues facing investors right now and explains why he's bullish on world growth.
The risk of recession
Over the first two months of this year everybody was concerned about the world going into some sort of depression or recession. We have a very different view. We think the odds of recession are a lot lower than the market expects—I think it's highly unlikely—and therefore we're reflecting a more 'bullish' view on world growth in our portfolios.
Firstly, US unemployment has come down. We haven't had a Great Depression, we haven't had a repeat of the 1930s. Monetary and fiscal policy has worked, and the youth unemployment rate is back to where it was previously – very, very low.
There has been a one-off fall in headline inflation due to the collapse in oil price, but we're not in a deflationary world. Core inflation does exist and we're not in a world of mass unemployment. We're in a good scenario, not a bad scenario.
The thing that drives recessions is increases in interest rates. And the US Federal Reserve (the Fed) still remains very, very light on its feet. At its 16 March monetary policy meeting, it remained very, very accommodative, suggesting rates will stay low for longer.
It's also worth remembering it can take around two years for interest rate policy to work. So it will be some time before the small move the Fed made in December has an effect on the economy.
The oil price
The other thing to bear in mind is how the oil price works. When the oil price goes through the roof, as it did in the 1970s, or the Gulf War, or events around 2000 –2001, that increase in oil price slows the economy down with a lag.
It does so for two very simple reasons. One, it acts as a tax. You need to consume oil. It's pervasive through all sorts of commodities, all sorts of travel. So by definition it acts as a tax on the West. And a tax slows down economic growth.
Similarly when the oil price goes up, inflation goes up. And central banks don't look beyond that. So if the oil price goes up they fear inflation and put interest rates up. So that's the monetary tightening.
So an increase in the oil price is also monetary tightening and fiscal tightening. And if you have these two types of tightening, low and behold, the economy slows.
Stimulus and inflation
At the moment, we've obviously got the opposite in terms of oil price. The oil price is falling, so that's a 'tax break' for everybody. That's fiscal stimulus for the West.
At the same time, because inflation is so low, it means monetary policy remains accommodative. As has been shown by the Fed yesterday and as has been shown by the European Central Bank last week, who are desperate to hit their 2% inflation target.
Hitting a 2% inflation target when the price of oil has gone from $150 down to $30 is pretty difficult. The only way to do that is to have huge monetary stimulus, and that's what they're doing.
So we don't think we're facing a recession. Rather, we see the low oil price as good for the economy and good for credit.
So how is all this affecting the bond market? Corporate bonds in particular are providing really good value versus government bonds. They are not the cheapest they've ever been—not as cheap as they were in 2009 or 2012, say—but they are good value. There are areas that are particularly good value, especially when you look at the US.
For example, we far prefer US dollar investment grade bonds to something like euro investment grade bonds. And we prefer investment grade generally to high yield.
Although we don't carry any currency risk in the portfolios—it's all hedged back—we do think there is better value in the US than the UK on a historical basis. We believe the US bonds are priced for recession, but the US economy is doing just fine.
Any significant changes to the portfolio so far this year?
The main thing that's happened over the last few months—in the weakness that occurred in January and Feburary—is we've gone from being about 25% in high yield to around 32–33%. So a third of our portfolio is now in high yield.
That's a neutral position for us. We're an index-aware fund, as opposed to an index-tracking fund, but if everything was perfectly priced, we'd be a third in high yield bonds, a third in government bonds and a third in investment grade bonds. And so we've moved to neutral in high yield from being underweight.
Investment grade, as I said, we think is really good value, so we remain a big investor in that. And then we have a portion in government bonds of around 10%, which is in fact a typical position in gilts for us. So at the moment, we're not as defensive as we were in 2006–07 and not as aggressive as we were in 2010 and 2012.
And for the first time since the fund launched, we have no equities in the fund. We only buy equities when they're exceptionally cheap versus bonds.
It's true that at the sector aggregate level, equities do look cheap versus bonds. But when we drill down through our stock selection process, it's very hard for us to find stocks that work for us. Hopefully at some point this will reverse and then we can pull the trigger and get involved in those individual stocks where the income stream from the equity is superior to the income stream from the bond.
Where to next?
Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. Richard's views are his own and do not constitute financial advice.