Recent volatility in government bonds has raised the spectre of a more large scale sell-off in fixed income markets, according to Nick Mustoe, Invesco Perpetual’s chief investment officer, who argues central banks look increasing set to botch their strategies.
Bonds have become one of the most expensive parts of the market in recent years but surprised investors last year by outperforming equities – despite some notable commentators such as Bill Gross calling the end of the 30-year fixed income bull run.
Performance of indices in 2014
Source: FE Analytics
However in recent months these gains have been somewhat eroded and gone through several sell-offs, albeit fairly marginally.
Mustoe (pictured) says this tendency towards greater volatility is starting to broadly “rattle markets” making central banks’ precarious task of precipitating a turn in the interest rate cycle even more dangerous.
“There is a growing risk of policy error in the UK and US given that the labour market is tightening and that wage growth has accelerated in both countries. It won’t take much for policymakers to find themselves behind the curve,” Mustoe said.
“European bond markets in particular have seen yields bounce decisively off low levels. The 10-year German bund yield, which fell as low as five basis points in mid-April, has moved as high as 78 basis points in recent weeks,” he added.
“Meanwhile, the price of the 30-year bund, issued at par last spring, and which subsequently traded as high as 160, is now at 130 having retraced all of this year’s gains. It is hard to attach any fundamental explanation to the rise in yields.”
The past couple of months have been a tough time to own a bond fund with the average fund in every bond sector apart from IA Sterling High Yield down since the beginning of April when the market began to sell off on a host of fears.
Performance of fixed income sectors since 1 April
Source: FE Analytics
“For some, the sell-off was simply a correction to the strong rally in bond markets earlier this year. When the European Central Bank [ECB] launched its QE programme in March, investors piled into eurozone debt, pushing up bond and equity prices and driving the euro sharply lower. This crowded position could well have left the market vulnerable to small shifts in sentiment,” Mustoe said.
“For me, government bond yields still look too low despite the QE programme, which has in effect anchored them at record low levels. In his latest speech, ECB president Draghi said that the unconventional measures have been potent so far, that the QE programme will be implemented in full and that it will last until a sustained adjustment in inflation has occurred.”
“Meanwhile, should the US Federal Reserve deliver a hawkish surprise in the form of raising interest rates then it could rattle markets further.”
Mustoe heads up the £309m Invesco Perpetual Managed Income fund, which sits in the IA Mixed Investment 40%-85% Shares sector and has just 13.87 per cent in fixed income. This is almost entirely through the £5.5bn Invesco Perpetual Corporate Bond fund.
This fund is fully invested in fixed income markets – with about three quarters in UK and European credit. It too has lost money in the sell-off but has held better than most funds in the IA Sterling Corporate Bond sector, being down just 0.77 per cent.
Performance of fund and sector since 1 April 2015
Source: FE Analytics
Mustoe also runs the £940m Invesco Perpetual Global Equity Income, fund in which his largest regional bet is Europe ex UK which accounts for 38.4 per cent of the total portfolio.
“Within equity markets, European stocks have benefited from improving economic and survey data. That has been especially the case for PMI data, notably for the service sector. However, there has recently been a greater spread between countries with Germany, Spain and Italy stronger but France weaker,” Mustoe said.
“First quarter gross domestic product data meanwhile showed a surprisingly good number for France. The earnings season appears to be strong with 70 per cent of companies beating revenue, and 60 per cent beating profit, forecasts.”
However, the manager – who has little in Japan – says he is increasingly bullish on the country despite this year’s rally and more recent tumble.
“The Japanese equity market has performed well year to date benefiting from improved profitability versus expectations for Japanese corporates, as well as reforms to corporate governance codes,” he said.
“Encouraging firms to reduce their large cash piles and return cash to shareholders in the form of dividends or buybacks is a shareholder friendly action and on that basis I am upgrading my outlook for Japanese equities.”