Pockets of value in the bond market
Having experienced a significant bounce back from the falls in March, corporate bonds are not as...
“Each stock market cycle has a regime – a prevailing system that is in power. Certain stocks or assets reign supreme for a period of time, but often carry the seeds of their own destruction. When the hype is no longer supported by valuation, they can fall from grace quite rapidly.”
That’s the view of Rob Burdett, co-manager of BMO MM Navigator Distribution fund.
Looking back over the past few decades, this pattern is easy to see. The 1960s was all about the Nifty 50 – the 50 largest companies including Xerox and Polaroid. Due to their proven growth records and continual increases in dividends, they were viewed as “one-decision” stock picks: investors were told to buy and never sell.
The 1970s were led by commodities, while the 1980s were fuelled by Japanese real estate – peaking when Tokyo’s Imperial Palace was worth more than the entire state of California, and golf club membership could cost US$3 million.
Technology stocks boomed in the 1990s and commodities and house prices soared in the early noughties.
In recent years we’ve swung back to technology stocks and growth stocks – what Rob calls a “duration regime” – in layman’s terms low interest rates have been key.
“With government bond prices driven by falling interest rates over the past decade, and a low growth environment, investors have wanted to be in high growth companies. But is the wobble we’ve just experienced in the FAANGMs (the big US tech stocks) the end of the current regime?”, he asked.
“Cash is cheaper than free and zombie companies, which probably should have gone bust, have been able to refinance. Interest rates can’t go much lower and, if the cost of borrowing goes up or we get some inflation, it will alter the perspective.
“When a regime changes, the future has to be different. Last year, value sectors looked cheap but there was no catalyst for change. Now we have one: government spending. Inflation is hard to measure at the moment as there are a number of short term deflationary aspects – like ‘eat out to help out’ which means restaurant meals have been cheaper. But we are seeing some things that could change that.
“At this point, the amount of government spending to help business and people out of this crisis is unprecedented – more even than during world wars. And we don’t know what the effect will be.
“It’s odd to think that inflation could go up in a recession, but there is scarcity of some goods and services – fewer tables at pubs, higher prices at the dentist to pay for PPE and NHS pay rises, are just a few examples. We’ve also got companies moving from ‘just in time’ production to ‘just in case’ – all this will add to the price of goods. So even if demand falls, prices could go up. Eventually this will put pressure on interest rates.
“Change is in the air and a diversified approach may now be the best option. Stock selection, rather than style, could start driving profits.”
Jonathan Golan, manager of Schroder Sterling Corporate Bond, agrees that individual stock selection will be key going forward in the bond market, as well as the equity market. “The corporate bond market broadly isn’t that attractive at the moment,” he said. “The easy gains have been made in the past six months and we’re now in a golden era for people who can do the credit work – the labour-intensive research to choose very carefully and generate returns going forward.
“There are pockets of value in corporate bonds, but you need to have high conviction in the companies that can recover and come back stronger – the industry champions. You also need a margin of safety, with bond yields compensating you for the risk you are taking.”
Rob Burdett believes that commodities could do better now, especially if we see economies recover, helped by more government funded or incentivised infrastructure projects.
“In broad terms, smaller companies should do better too,” he said. “They usually trade at a premium to reflect superior growth but that has not been the case recently. They’ve been trading at a discount due to liquidity and a boom in passive investment, so they’ve got left behind.
“Value strategies could also do better, but investors need to remember there are different types of value. If you are just looking for a cyclical rebound in media or airlines, there’s quite a lot of risk at the moment. So chose value manager very carefully and understand the risks they are taking.”
Chris Ford, manager of Smith & Williamson Artificial Intelligence fund, is also looking to the future. In his most recent update he said: “At the time of writing, equity markets and particularly the so-called ‘FAAMG’ names are undergoing a correction.
“In our opinion, this is likely to be a short-term event but given the phenomenal run for equites over 2020 to date, it was probably overdue. Technology and related areas have performed exceptionally well for the fund, but now we think the time is ripe to think about what the world might look like next year and position the portfolio accordingly.
“Specifically, we think that industrials and other non-tech areas could offer interesting opportunities as the world begins to return to normal, albeit slowly and incrementally. Our hope is that economies will return slowly to some kind of normality and that the winter months can be negotiated without too many further setbacks for populations or economies.
“Of course, there remains the risk that a second wave could force further restrictions and lockdowns, both here and abroad, and in that event the ‘stay at home’ plays that are currently having a tougher time after a stellar 2020 could find renewed favour with investors.”