Investors should prepare for interest rates to rise globally, according to GAM model portfolio manager Charles Hepworth, who said he has moved to an underweight position in long duration assets to reflect his expectations.
Fixed income has been one of the top performing asset classes to be invested in for the last few years with the Barclays Global Aggregates index up 24.49 per cent over five years.
Performance of index over 5yrs
Source: FE Analytics
Yet, there are concerns over whether there could be a reversal in the current ultra-low interest rate environment that has been so accommodative for bonds and Hepworth said therefore he is significantly underweight duration in his model portfolios.
“The current aggregate is around four and a bit years,” he said, which is much shorter than the benchmark UK bond index.
Indeed, the FTSE Actuaries All Stocks Index has a modified duration of 11.18 years, though the portfolio manager noted that it is probably slightly higher compared to a global index due to the UK government’s recent issuance of ultra-long-term debt which has “kicked out the duration a little bit”.
However, even when compared to the global government bond index, which has a duration of about seven or eight years, Hepworth retains a shorter duration exposure.
“Basically this is because our expectation is that rate policy globally is now getting into slightly tighter conditions,” he said.
Indeed, the manager noted that central banks around the world have begun to increase the amount of pro-interest rate rise rhetoric while in the US the Federal Reserve have already started raising rates.
“I think everyone is aware that we’ve gone through a period ultra-loose monetary policy – for example it’s been 10 years since the UK’s last rate hike,” Hepworth said.
“The general perception is that rates across the globe are going to go higher and that is going to have an impact on bond market performance and whether they’ve factored a lot of that rate pressure going higher in is a big question for debate.
“If they are moving more aggressively [than expected] then markets will have to react and price accordingly but right now the market is not necessarily totally believing that the Fed or even the European Central Bank [ECB] are going to be aggressively moving higher.”
However, one area investors should not expect to see an interest rate hike is in the UK, where despite recent statements about the potential for a rate increase from Bank of England governor Mark Carney, Hepworth said there is a low chance of a tightening cycle.
“I don’t honestly believe that the Bank of England are going to raise rates given the outlook for the political environment over the next year or two on Brexit,” he said.
“I just can’t see that they are going to follow through on a lot of the rhetoric that Carney has come out with recently.”
This is despite interest rates remaining near record lows, as the below shows, with the FTSE Actuaries UK Conventional Gilt GR Yield 10 Years index down 76.08 per cent over the last decade.
Performance of index over 10yrs
Source: FE Analytics
Hepworth said Carney is telling markets that he is on watch to raise interest rates to defend sterling, which plummeted following the UK’s decision to leave the EU in last year’s referendum.
Indeed, since then the pound has fallen 13.01 per cent against the US dollar, as the below chart shows.
Performance of sterling vs US dollar since EU referendum
Source: FE Analytics
“He doesn’t want to see this rampant inflation shot coming through because of the sterling move that we’ve seen year-to-date and really since this time last year after the referendum,” Hepworth said.
“So he will say that he is vigilant to raise rates but whether they are actually going to go through with a rate hike is another question and I don’t think it is likely for the foreseeable [future].”
Despite this, the manager said investors should expect to see interest rate movements in other areas. “Ignoring the UK, still globally rates are going to have to move higher,” he noted.
“There are really stretched valuations on government bond markets and there is only one real scenario going forward and that’s that you are going to be losing money on your capital as rates do generally move higher and the expectation of rates moving higher gets priced into bond markets.”
As such, he is underweight fixed income in his model portfolios, a decision he said has worked over the last few years.
“So we want to be underweight duration and underweight the asset class in general,” he said.
Indeed, while he does own some exposure, it is to the more risky, higher returning sectors such as emerging market debt, junior credit and mortgage-backed securities.
By allocating away from government bonds – indeed he has no gilt exposure in the portfolio – Hepworth has managed to make a return of 3.3 per cent from his fixed income allocation so far this year, compared to a completely flat – zero per cent – return for his models’ benchmark.