Inflation: will it stay, or will it go?
Inflation is the buzzword in markets at the moment. Prices have risen 5% year-on-year in the US and...
To mark the 10th anniversary of the Elite Rated M&G Optimal Income fund , we look at the past decade in fixed income investing and how its manager, Richard Woolnough, sees the outlook for 2017.
Back in December 2006, when the M&G Optimal Income fund was launched, investors had little idea of the scale of the challenges lurking just around the corner. Markets were still booming and investors were blissfully unaware of what was to come: the US sub-prime mortgage crisis that kicked off in 2007, leading into the Great Financial Crisis, swiftly followed by the eurozone crisis.
Markets have been no less interesting since then, and 2016 has proved to be a case in point. A year ago, who would have realistically expected the UK to vote in favour of leaving the European Union, and the USA to choose Donald Trump as its president?
According to M&G, yields on US Treasuries spiked sharply in reaction to Trump’s election, wiping an estimated US$1 trillion off the value of bonds in the week of the election alone. Regardless of whether this turns out to be just another blip, or the start of a more sustained move back towards ‘normal’ yield levels after years close to historic lows, it shows just how challenging it can be to stay on top of asset allocation decisions in such fast-moving markets.
The M&G Optimal Income fund has the flexibility to invest across a broad range of fixed income assets according to where Richard identifies value. He even has the ability to invest a portion – up to 20% – of the fund in equities if the stock of individual companies looks attractive relative to their bonds.
Since its inception, the fund has navigated a number of bull and bear markets and Richard has not been afraid to make the big calls that such challenging times demand. This has allowed the fund to deliver outstanding risk-adjusted returns in the face of some of the most volatile markets in living memory.
It has been many years since inflation has been a topic of concern for investors in developed markets. But this is finally starting to change, and the recent US election outcome will only speed up the rate at which this happens, in Richard’s view.
The market expects President-elect Donald Trump to increase fiscal spending and widen the US budget deficit, which is likely to push inflation higher more quickly. Richard has long believed that interest rates in the US need to rise imminently to curb future inflation. This is because monetary policy can take up to two years to have an impact.
Meanwhile, although UK interest rates are not expected to rise significantly in the immediate future, the weakness of sterling since the EU referendum result means that inflation is once again back on the agenda here too. For many investors, this could be their first real experience of an environment of rising inflation expectations, interest rates and bond yields.
In such an environment, funds such as the M&G Optimal Income fund have a number of tools at their disposal. For example, Richard could invest in parts of the market that are less exposed to interest rate risk, such as high yield bonds, depending on where he sees value.
The fund has long been positioned according to Richard’s view that the global economy is recovering. He expresses this through investing in bonds with a short time to maturity, known as ‘short duration bonds’, and a substantial exposure to credit (both investment grade and high yield). The fund’s duration has hovered between 1.9 years and 2.2 years in 2016, with the exception of a temporary rise immediately after the Brexit vote.
In the latter stages of 2016, the fund has been broadly neutrally exposed to high yield reflecting the fact that investment grade credit has started to look somewhat less attractive than high yield. Richard has also established a small position of around 5% in equities for the first time in nearly two years.
While it will be some time before the consequences of the UK’s decision to leave the EU are fully understood, what is certain is that the outcome changes the trajectory of the UK economy and, at least temporarily, raises questions over the future of the EU. Market volatility will also likely continue, in Richard’s opinion, as investors express their reaction to that uncertainty.