There are still a lot of reasons to be concerned about not just the US economy but the global economy, according to Craig Veysey, manager of the Sanlam Strategic Bond fund. 
While many are anticipating a sharp steepening of the yield curve thanks to rising interest rates in the US and improving global economic data, investors should remain cautious in 2017, with the ‘lower for longer’ rhetoric likely to come back by the end of the year, the manager says.
“There are reasons why the Federal Reserve have kept rates at very low levels for so many years and reasons why the ECB and the Bank of Japan continue to pursue QE and why rates in the UK are not likely to go up in the near term. It’s because we still have a very poor global economic background,” he said.
The manager runs the five crown-rated Sanlam Strategic Bond fund, which has been a top quartile performer in the IA Sterling Strategic Bond sector over one, three and five years.
Performance of fund vs sector over 5yrs
Source: FE Analytics
As the above graph shows, the £87m bond fund has returned 42.90 per cent over the last five years, 13.64 percentage points ahead of its sector.
Veysey owns a core holding of corporate bonds that make up between 70 and 80 per cent of the fund and uses the remainder on his best ideas.
The manager says while there is expectation baked into markets concerning Donald Trump’s policies, inflation expectations and the pace with which the Federal Reserve will look to raise interest rates, these are not yet known and the market has been too quick to accept them as facts.
“Okay, there is hope and expectation that things are going to improve in the near term and Donald Trump and his fiscal expansion policies are right in the centre of providing a lot of hope to markets in the near term and recent months,” he said.
“But whether or not that can counteract the significant downside structural forces which have been pushing down on bond yields over the course of the last 10 years I think the jury is very much out on that particular question at the moment.
“We’ve had many attempts to try and stimulate the economy from having very low rates and quantitative easing policies and the buying of corporate, government and mortgage-backed bonds since the financial crisis and none of them have really managed to produce significant upside or consistent growth momentum for the US economy.”
This failure, he says, has been down to a number of factors including poor demographics, relatively low productivity rates and relatively high debt levels.
“The hope at the moment is that Trump is able to put in place some significant tax cuts, infrastructure spending, etc, which changes that dynamic.”
“But it’s difficult to see whether or not that can actually do the job,” he says, adding that further questions as to what extent the government can actually change the tax rate in the near term and when they are going to start the infrastructure spending linger over markets.
“At the moment there is a lot of strong optimism around the policies of the Trump presidency but there isn’t a lot of detail about what they are going to do or when they are going to do it so therefore it is quite difficult to actually expect that there’s going to be a significant turn over the course of the next six to 12 months from my point of view.”
As such he says he expects yields to remain as they have done for the last several years – low.
Performance of index over 5yrs
Source: FE Analytics
As the above graph shows, bonds have had risen sharply over the last two years and this has led to a sharp fall in yields as the two are negatively correlated.
“At the moment I think the jury is still out and I don’t think we have any clear evidence that the situation has turned materially,” Veysey said.
“I think it’s very difficult to make a coherent argument unless you are embracing a lot of guesswork that we are definitely going to come up with the view that central banks and governments around the world are going to be able to turn around the significant underlying structural story that has been in place over the last five years or so.
“It may be the case that they can but I certainly as a fund manager wouldn’t position significantly for it and I think markets have and I think that should be a concern.
“Generally I would expect that the situation that we have had over the last five or six years will probably come to fruition again over the course of the next 12 months in that yields might rise a bit higher in the near-term, perhaps because markets might anticipate higher or a faster pace of tightening from the Federal Reserve and then therefore they might price in slightly higher treasury yields, but I think that will just provide an excellent opportunity to buy treasuries.”
However, one area he is buying is US treasury inflation protected securities – or TIPS – as there is potential for rising inflation over the coming year due to the sharp climb in energy prices.
Indeed, as the below graph shows, Brent crude has risen 46.87 per cent over the last year, though this is from a very low base after prices plummeted in 2014.
Performance of index over 1yr
Source: FE Analytics
Although inflation would have a detrimental impact on the real return you get from treasuries it has a positive impact on TIPS, he says.
“Of course, if the TIPS prices were to rise significantly more than your anticipated inflation expectations then of course they would become overvalued but at the point at which we were adding them to the portfolio we still had fairly low inflation expectations incorporated within the price compared to the general expectation of inflation over the course of the next six to 12 months.”
The manager says he still likes TIPS in the current climate, which have a 4.5 per cent position in the fund, though if energy prices were to fall he would expect this to have a detrimental impact on inflation expectations and therefore TIPS.
“In that case you would look to cut back on your TIPS holding because it would be likely that market-based inflation expectations would start to come down and that would be reflected in the prices,” he said.
However, he added: “I still think– particularly in the current environment where you’ve got clearly quite a positive expectation for economic growth momentum in the near-term for the global economy and more so for the US economy because of Trump’s fiscal expansion policies – then TIPS can still do quite well.”
The reason for this is that the 10-year breakeven inflation rate in the US is 2.02 per cent, which he says present risks to the upside for investors.