Time to reassess as winding down of QE takes wind from the sails of gilts and bonds
The last twelve months have seen the performance of the Tugboat portfolio stagnate as for the momentum investor it ran out of puff; historically it has invested its money into the Investment Association (IA) sectors according to, and limited by, the percentages allowed for in the Saltydog group pie-chart.
This pie-chart requires that 70% of the Tugboat funds should be placed into our ‘Slow Ahead’ group in the attempt to make it secure within what we believed were the least volatile IA sectors – these consist mainly of bonds and gilts. Unfortunately, their prices appear to have peaked and there is little oxygen left in these sectors; their trend is now down and the ‘slow ahead’ group has become the ‘Slow Astern’!
The worst performing sectors in this group over six months were £ Corporate Bonds and £ High Yield Bonds – here’s how the leading funds in these sectors have performed.
The highest return was 0.6% over six months, and most of the funds actually went down over this period.
Even the funds from the best performing sector in the ‘Slow Ahead’ group have struggled; the leading funds in the Global & Global Emerging Market Bonds sector have made some progress over the last three months, but this is accounted for by currency movement rather than the underlying strength of the assets.
The change in fortune for the funds in this group has been caused by the reduction or removal of Quantitative Easing (QE) around the world and the rise in interest rates in America.
QE is where central banks buy assets to try to stimulate the economy. Here’s how the Bank of England describes the process …
‘Quantitative easing is when a central bank like the Bank of England creates new money electronically to make large purchases of assets. We make these purchases from the private sector, for example from pension funds, high-street banks and non-financial firms. Most of these assets are government bonds (also known as gilts). The market for government bonds is large, so we can buy large quantities of them fairly quickly.
The purchases are of such a scale that they push up the price of assets, lowering the yields (the return) on them. This encourages those selling these assets to us to use the money they received from the sale to buy assets with a higher yield instead, like company shares and bonds.
As more of these other assets are bought, their prices rise because of the increased demand. This pushes down on yields in general. The companies that have issued these bonds or shares benefit from cheaper borrowing because of these lower yields, encouraging them to spend and invest more.’
The amounts of money involved are eye-watering.
- In the UK the Bank of England has amassed £435 billion of assets but stopped adding to this last year.
- The European Central Bank has accumulated €2.4 trillion since it launched its quantitative easing programme at the start of 2015, and it’s still adding €30 billion a month. ECB President, Mario Draghi, has recently announced that this will drop to €15 billion a month after September and finish at the end of the year.
- The US figure peaked at $4.5 trillion. The Federal Reserve has stopped adding to this and is the first central bank to start unwinding the process – not by actually selling bonds, but by progressively stopping reinvestments when existing bonds mature.
- The Bank of Japan is now at a point where its assets amount to over 95% of GDP, at more than ¥500 trillion.
That means that together the European Central Bank, Bank of England, Bank of Japan and Federal Reserve have spent over £10 trillion trying to stimulate the global economy by pushing up the price of bonds so that the yields (returns) fall.
‘The future does not wait, just because we are not ready for it’
That’s an enormous amount of money; the current population of the European Union, the United States and Japan is still less than a billion people. That means that the total asset purchase program equates to more than £10,000 per person in those regions.
When you take that into account it’s hardly surprising that there’s been a long period when bonds and gilts have been going up in price and interest rates have been at record lows.
We’re now heading into a phase where the amount of stimulus has stopped going up and started to fall; if other central banks follow the Fed, and stop reinvesting when their bonds mature, then we’ll end up with Quantitative Tightening.
‘we’ve already started to see the sectors that did well under QE (bonds and gilts) starting to under-perform’
At the same time central banks are starting to raise interest rates; there have been several increases in the US and one in the UK, more will follow.
There is a direct relationship between bond prices and interest rates; simply put, if interest rates go up then the yield on bonds needs to go up (why buy bonds when you can get a better return from the Bank?). For bond yields to go up, their prices have to fall – as I mentioned earlier, we’ve already started to see the sectors that did well under QE (bonds and gilts) starting to under-perform.
The future does not wait, just because we are not ready for it, change happens whether we want it or not, so now is the time to fire up the Quattro and make a tactical retreat.
To address the changing environment, all the sectors are having their volatility calculations reassessed and the ‘Slow Ahead’, ‘Steady as she Goes’ and ‘Full Steam Ahead’ groups will be re-formulated according to their Vindex ranking.
This will mean that some sectors will move up, and some will move down, but at the end of this manoeuvre it should mean that the groups reflect what we are seeing around us now, rather than how things were in the past.
‘the total asset purchase program equates to more than £10,000 per person in (the US, EU and Japan)’
If we then establish that sectors in the ‘Slow Ahead’ group are no longer going to give us the levels of return that we were seeing a couple of years ago, then that will also mean that our algorithms will have to be tweaked to realign the pie-charts to reflect these changes.
We will review the rules for our Tugboat and Ocean Liner and are considering trialling a Speedboat portfolio; this could also invest in Investment Trusts (ITs) and Exchange Traded Funds (ETFs).
We produce the information for these funds on a weekly basis anyway and many of our subscribers, including myself, invest in this arena. This will get discussed more fully over the weeks to come.
I will leave you with this thought. As you get older you acquire silver in the hair, gold in the teeth, crystals in the kidneys, sugar in the blood and iron in the arteries. Who would have ever thought that you could accumulate such wealth?
Best wishes and good investing,