Bond to Fall in Janet Yellen and the Euro

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1 FUND MANAGEMENT DIARY Meeting held on 5 August 2014 Bond yields Yellen s dilemma The major questions now being asked by markets are concerns about the strength of the US recovery, the direction for interest rates and the pace of deficit reductions. It is strange that positive news on the economy is met with adverse reactions on the assumption that this brings forward the point when rates will rise and undermines the support for asset prices, which have relied on ultra-easy monetary policy. Janet Yellen continues to argue that there is still considerable slack within the economy, which with the absence of inflation, means that she will not be dissuaded from her overall objective of keeping interest rates low while maintaining the stimulus within her toolkit. However, while she is in the driving seat, there is mounting evidence that she is relying on the rear-view mirror, while not keeping alert to the road ahead. In this respect, while she maintains that the drop in unemployment to 6.1% has more to do with the long-term unemployed not remaining on the register, this ignores the fact that employers are now increasing their workforces and are also being forced to increase wages to attract competent personnel. The US economy is undoubtedly leading the world s expansion and from Fidelity Research, their Global Growth is showing an upswing, with its inflation scorecard turning positive. This is particularly evident in the UK, which is now showing the largest GDP growth figures in the developed economies, but more significantly, the Eurozone, which many economists believe needs to pull itself out of recession, now surprisingly has the Bundesbank positively encouraging employers to raise wages by 3% on the basis that workers and shareholders should benefit from an improvement in productivity, through an increase in aggregate demand. This is to reflect the ECB s policy to maintain a growth stimulus, which could eventually lead to QE and the fact that the Bundesbank is now giving its backing to core inflation, to endeavour to meet the ECB s inflation target of 2-3%. While there is insufficient space in this diary to point to all the positive signs both globally and in the, suffice it to say that Janet Yellen s remit for her current policy is the need for the Fed to continue to nurse the patient. Therein lies the dilemma, as the consequence of ending zero interest rates must also be the point at which the pessimism about the American economy ends. Previous chairs of the Fed have often become fixated on particular policies, such as Alan Greenspan s continual easing of interest rates with a view to supporting asset

2 and house prices, Ben Bernanke s suggestion that the sub-prime mortgage market problems had been contained and for the moment, the doves on the Fed committee hold sway. However, there is evidence that the hawks are now gaining ground with a view to monetary tightening and raising interest rates; a view which is gaining more and more traction with leading commentators. As set out in previous diaries, the Fed has indicated that QE will end in October and the overall exit strategies have been discussed and papers published, with the main considerations being with regard to reducing the debt burden and maintaining economic growth. Janet Yellen has expressed her concern about the fragility of the recovery and believes in the optimal control theory to manage US monetary policy, with interest rates being left low and permitting some inflation, with an overall 2% target and return employment to normal levels quickly. However, it has been pointed out that this policy is creating financial imbalances, with bubbles, particularly in risk assets such as high yield corporate bonds and equities with high beta values, together with negative implications for government bonds. While she acknowledges these concerns, it seems that she dismisses any consideration that in the not too distant future, the Fed will need to address signs of overheating in the economy and wage increases, giving rise to sustainable inflation. The Future Fund Management team believe that rate rises will be earlier than previously thought and in today s FT, the Short View states that it is accepted wisdom that the first rate rise from the US Fed, threatens the five year bull run in equities. However, it goes on to state that apart from two periods of stagflation, all that it has done is prompt a pause and minor corrections in the overall bull market. It then adds, inflation is equally calming, but if prices rise to more than 4%, this tends to spook markets, but again, small corrections usually result, although investors fret that it may run out of control. But inflation at 2.1% is far from the 4% threshold. It is our belief that while the ending of QE will have repercussions and give rise to some falls in markets, particularly in the asset classes previously mentioned, our overall view is that portfolio construction should be maintained, with a view to strengthening the alpha risk-adjusted sectors with security-specific portfolio differentials, which we believe will be ideal in the scenario as discussed. While there will be inevitable short-term sell-offs as asset managers look to adjust their portfolios to the positioning which we have stated continually in our strategy, we will look to buy on the dips, but we will not alter our maximum cash holdings from the consideration. While we notice that many managers are claiming that they are

3 raising their cash levels, we believe that this could be a mistake as timing is notoriously difficult and being out of a market, in which earnings and dividend growth is important, could be costly. Strategy Our strategy remains unchanged in that we favour equities as our preferred asset class, with an emphasis on earnings and dividend growth, with a concentration towards funds with strong alpha characteristics. We remain cautious on bonds in general, but look to special situation funds within our overall asset allocations.

4 Consideration is being given to the portfolio s exposure to high yield debt assets through its holdings in the Legg Mason Optimiser and the Henderson Strategic Bond funds. The lower credit rated end of the corporate bond market has performed very well over recent years and we are considering the ongoing sustainability of this. 39% 7% 40% Other 7% 2% Real Value Due to concerns over the large size of the fund and subsequent liquidity issues that may arise should sentiment deteriorate, the M&G Optimal fund will be removed from the portfolio. A small top-up will be made to the existing holding in the FP Brown Shipley Sterling Bond fund, however the remainder of the assets raised will be maintained as cash while a suitable alternative is identified. 24% 40% 20%

5 Real Growth For the same reasons as detailed in Real Value the M&G Optimal fund will be removed from the portfolio. This will be replaced with the AXA Sterling Credit Short Duration Bond fund. The Henderson Strategic Bond fund will be placed under review given its significant allocation to high yield bonds, as detailed in our comments for. 21% 7% 3 UK 1 8% Dynamic Growth The M&G Optimal fund will also be removed from Dynamic Growth. This will be replaced with the Kames Investment Grade Bond fund. We believe this to be more appropriate than the AXA fund being added to Real Growth, and which is already held in Real Value, for this higher risk portfolio. 12% UK 39% 20% 11% 2% Emerging 10%