ECB president Mario Draghi announced yesterday that he would cut interest rates to a record low and initiate a programme to buy asset-backed securities and covered bonds from eurozone banks in order to stave off deflation and generate economic growth.A number of experts and economists have welcomed the decision due to the poor data and falling inflation that has come out of Europe over recent months.
However FE Alpha Manager Woolnough, who heads up the £22.3bn M&G Optimal Income fund, says the European economy is far stronger than the market perceives.
In a web call on Wednesday, and therefore prior to the ECB’s announcement, he warned that the central bank would be making a mistake if it loosened policy even further.
“My general concern with the ECB is, why are they doing it?” Woolnough (pictured) said.
“They are doing it because they fear deflation, but you are always going to get periods of low inflation. They are semi overreacting.”
“The ECB looks like it is going to cut its rates to zero or even below zero and, general speaking, everybody thinks that they are acting correctly. Is that the same ECB that was putting rates up in 2008? Is that the same ECB that was putting up rates in 2011?”
“They’ve made mistakes one way, maybe they are cutting rates at a time they don’t need to be.”
Europe has been the perennial source of bad news for the global economy over recent years.
Performance of index over 2yrs
Source: FE Analytics
Though its equity market has made strong gains over recent years, many are concerned that the rally is not sustainable because the economic outlook is poor.
Woolnough, on the other hand, disagrees and says that the currently extremely low bond yields in the eurozone don’t make sense.
“Europe has got itself into a funk about deflation and the economy being weak. It’s been this weak before, it’s got monetary policy coming to rescue it; things aren’t going to be as bad as people expect.”
The major reason for that is because of interest rate policy, according to Woolnough, who says there is always a lag in the economy when interest rates either rise or fall.
“We think the main driver of a macroeconomic cycle is the cost of financing, because it tends to slow the economy when rates go up and it tends to accelerate the economy when rates go down,” he said.
“What happened in 2010 and 2012 was one of the most severe monetary tightenings in history as there was a huge rise in interest rates. If you look in any economics book, it will tell you that the economy is going to slow and unemployment is going to go up; but with a lag.”
The manager therefore says the European economy in 2013 and so far in 2014 has been a function of the ECB’s rate hike in 2011, so investors are overreacting if they think the situation is going to get materially worse from here.
“No wonder it is weak, no wonder there were problems and no wonder inflation is low,” the FE Alpha Manager said.
“But going forward, where is growth going to be and where is inflation going to be? You have had a situation where interest rates have gone down dramatically both in the core and the periphery. Again, monetary policy will work, but with a lag.”
“We think that fears over both deflation and the eurozone economy imploding and coming to an end are based on sideways, or backwards, looking analysis as opposed to forward looking analysis. Monetary policy does work, and I think is working, the economy isn’t as weak and deflation isn’t such a threat as the market perceives.”
Given his outlook for the economy, he thinks European bonds are too expensive.
For the first time in his five crown-rated M&G Optimal Income fund, he has gone short duration in Europe relative to his peers.
This position has hurt the fund recently and, according to Woolnough, is the main reason why he has underperformed so far this year.
Performance of fund vs sector in 2014
Source: FE Analytics
However, the manager says this is unlikely to continue.
“This is the best value you’ve ever had to own UK bonds versus German bonds. UK bonds now yield 1.5 per cent more than German bonds and that is attractive to us.”
“We don’t think the economic cycle is that divergent, we don’t think Europe is as bad as people think it is, we think it will eventually recover and therefore we don’t understand why rates should be this far apart.”
“We think the ECB is making a mistake by worrying too much about low rates and low inflation. They are looking too much outside of the side window and needs to look forward.”
The fund’s numbers this year haven’t affected its longer-term track record, however.
According to FE Analytics, M&G Optimal Income has been the best performing portfolio in the IMA Sterling Strategic Bond sector, and has outperformed all the other IMA Sterling bond sectors, since its launch in December 2006 with returns of 88.27 per cent.
Performance of fund vs sectors since Dec 2006
Source: FE Analytics
The fund has also outperformed over one, three, five and seven year periods having beaten the sector in every calendar year since its launch, except in 2012 when it underperformed by 0.4 percentage points.
However, given its current £22.3bn size, questions have been raised as to whether Woolnough will be able to maintain that level of outperformance.
M&G Optimal Income yields 2.43 per cent and has an ongoing charges figure (OCF) of 0.91 per cent.
