The widely anticipated sell-off in fixed income is still very much on the cards, according to M&G’s Jim Leaviss (pictured), who has been reducing his duration exposure across his funds due to the likelihood of wage growth and a pick-up in inflation. 
There have been growing concerns that a large correction in the bond market is imminent due to the historically low yields on offer and the fact that the US and UK economies are improving, but fixed income – despite a sell-off earlier in the year – has largely held up well in 2015.
However Leaviss, who is head of retail fixed income for M&G’s mutual fund range, says that this widely anticipated sell-off is drawing nearer and nearer.
“Bond yields have risen throughout this year, but it’s not been the big sell-off that we’ve been anticipating, I think that will come once people realise that wages are increasing on an ongoing basis,” Leaviss (pictured) said.
Many bond investors have been bearish this year, following Federal Reserve chairperson Janet Yellen’s announcement in September that the US will adopt a “gradual pace of tightening” before the year-end, leaving fixed income looking highly vulnerable.
Performance of indices in 2015
Source: FE Analytics
“As we know, the big missing piece of the puzzle for consumers, for economists and for the developed world is missing wage inflation, and the fact that even though we’ve had some growth since the financial crisis, we haven’t been able to generate increases in living standards for populations,” Leaviss explained.
The manager had always thought that the time to go into short-duration assets in the M&G Global Macro Bond fund would be when wage inflation started coming through.
Up until now, he says, wages have remained at around 2 per cent growth or lower, which he believes hasn’t been enough to generate a ‘”feel-good” factor and drive the consumption levels needed to keep economies growing.
Now though, Leaviss says the economy is at a point where income levels are high enough to push wage inflation, which will ultimately change the landscape for bond investors in the foreseeable future.
“You’ll remember the unreliable boyfriend Mark Carney said that once UK unemployment hits 7 per cent, that will be the time that the UK will start raising rates as part of the Forward Guidance programme,” Leaviss continued.
“That didn’t happen and the unemployment rate since 2011 came down from nearly 9 per cent to below 5.5 per cent where we are now. But it’s only really once we hit 5.5 per cent in the UK that suddenly wage inflation leapt up from 2 to 2.5 per cent and since then all the way up to approaching 3 per cent where we are now.”
“It feels as if the slump in the UK labour market has finally been taken out and wages can now start to grow. It’s new, it’s important and it does change the interest rate environment in the UK.”
The manager says that there is a similar situation occurring in the US. According to recent data, there is currently a 5 per cent unemployment rate in the region, and this is the level that he believes is set to generate wage inflation.
As such, the team at M&G is expecting a rate hike in the US next month providing this trend in wage growth is sustainable.
Now that it has been seen on an economy-wide level, Leaviss says that the team could end up taking the duration of funds such as M&G Global Macro Bond negative.
“At the moment we have a duration of around two years in the fund, which is significantly shorter duration than most global bond funds,” the manager said.
A second factor that Leaviss says is hugely significant for bond funds at the moment is the inflation outlook.
The latest CPI figures are due from the Office for National Statistics tomorrow, and many economists believe that the continuation of supermarket price wars as well as low oil prices will keep UK inflation in negative territory.
In Europe, president of the ECB Mario Draghi announced last week that inflation levels in the region were also disappointing, and that it is likely QE will continue past September 2016 within the eurozone.
“One thing that’s very important to note is, while we’re at -0.1 per cent inflation in the eurozone and similar levels in the US and the UK, if you break down where that contribution is coming from, the service sector inflation in the eurozone is still above 1 per cent,” Leaviss pointed out.
“Goods are at very low levels partly because of China exporting very cheap goods as it’s trying to export its way out of economic problems, but you won’t be surprised that the big contributor to what is driving the low levels of headline inflation is energy.”
The manager says that the halving of the oil price over the last year hasn’t just impacted on inflation values through direct energy costs, but through factors such as the transporting goods and services and through the heating and lighting of business and households.
“We’re going to have to see a halving of the oil price again down from $50 to $25 over the next year. Then the next year has to go $25, then $12.5 and so on. We are going to have to see further consistent falls year after year in the oil price just to maintain the inflation level we’re at now,” Leaviss said.
Performance of index over 2yrs
Source: FE Analytics
“This means that, if we look through to the start of 2016, we know that inflation is going to start picking up.”
“We’re not going to see this halving of oil prices again, we know what the base effects are, and it looks to me as though central banks have an excuse to hike rates - it’s been a terrible time if you’re the Fed at the moment where you want to hike rates. But how do you do that in a world where headline inflation is trending downwards?”
Moving into 2016, the manager believes that the base effects from the low oil price will start to drop out, which is another reason that the team at M&G think there is a 70 per cent chance the Fed will hike rates before the year end.
“We don’t really care whether it happens earlier than 2016, nothing in our portfolio is really dependent on the timing whether it’s next month or three months later, but rates are going up in the US and the UK and this is all about the energy price,” Leaviss said.
Since Leaviss launched the fund 16 years ago, M&G Global Macro Bond has returned 118.18 per cent, outperforming its peers in the IA Global Bond sector by 7.94 percentage points.
Performance of fund vs sector since launch
Source: FE Analytics
The £1bn fund has a clean ongoing charges figure of 0.8 per cent and yields 1.42 per cent.
