Navigating Rates
Despite the rally in global government bonds over Q4 of 2023, we continue to have a high conviction view that developed market interest rates will likely be far lower than markets are pricing in for 2025-2030. This is particularly true for gilts, where we believe that growth will continue to flounder, and where we think inflation could continue to fall more sharply than markets are anticipating.
We don't have a strong view of the near-term timing of when the Bank of England (BoE) will cut rates, where at the time of writing, the market is pricing in three BoE rate cuts by the end of Q3 of 2024, which looks broadly correct. But ultimately what matters more for the gilt market is where the BoE base rate will be in 2025-2030, rather than in Q2 or Q3 2024. We still believe that the UK economy, like much of the rest of the world, has still not yet felt the majority of the aggressive rate hikes of 2022-2023, given that it takes around 12-18 months for any change in interest rates to have an effect on the economy. If growth does continue to weaken, then this might even push UK inflation below target.
The first chart below shows the market-implied forward path of overnight rates, derived from the GBP interest rate swap curve, month by month, over the next 10 years. The course of the blue line shows that the current shape of the GBP yield curve implies overnight interest rates (which are closely following the BoE base rate) to remain above 3% until 2026 and to not fall below 3% ever again over the next 10 years. Note that this is derived from the swap curve, where implied interest rates from the gilt market are even higher beyond 2025.
Source: Bloomberg, data as at 15/01/2024. Past performance does not predict future returns.
It would make sense for markets to price in historically high nominal interest rates for a long period of time if markets were very concerned about long-term inflation dynamics. However, this is not the case, where inflation markets are instead pricing in a sharp drop of Retail Price Index (RPI) inflation to a level of 3.5%1 by mid-2024. Taking into account the historical wedge between the Consumer Price Index (CPI) and RPI, the market is expecting CPI inflation to fall back to 2.5% quickly. While this is above the BoE’s 2% target, it’s worth bearing in mind that market implied inflation will include a risk premium – inflation protection is like an insurance contract, and people pay up for protection. Insuring against UK inflation is likely to be very elevated at the moment, implying that that market’s ‘pure’ view of where medium-term inflation is headed is likely closer to 2%.
Source: Bloomberg, data as at 02/01/2024. Past performance does not predict future returns. EUR HICPxT = The Harmonised Index of Consumer Prices of the euro area, excluding tobacco
The two charts above combine to imply an economic scenario where inflation is quickly falling back towards target, whilst not only will a recession be avoided, but growth will be above trend over the next few years. In other words, there is a divergence between the scenario priced in by inflation markets and what rates markets are expecting – markets are indicating that nominal interest rates will be maintained at ~1% above inflation.
We think inflation market pricing is currently fair. Global producer prices across major economies (including the UK) are now deflationary and producer prices tend to lead headline inflation, which leads core inflation (please see our blog for further detail).
It is the rates market that is mispriced in our view. We do not think that the economy is immune to the super aggressive global monetary tightening kicked off by the BoE at the end of 2021. There are some arguments that can be made for why the lags between interest rate increases and their impact on global growth this time around may be a little longer than the ~12 months historically seen in economic cycles (eg excess savings, still elevated corporate earnings, households and corporations terming out debt in 2020, labour hoarding etc). But this just delays the crunch, it doesn’t prevent it.
If the BoE follows the path priced in by the rates market, we have little doubt that the BoE will succeed in destroying aggregate demand. Indeed, Swati Dhingra, a member of the BoE’s Monetary Policy Committee, in October 2023 estimated that only 20-25% of the BoE’s interest hikes had so far fed through to the economy. We are seeing clear signs of slack appearing in the labour market, which is evidence that all the BoE hikes are succeeding in breaking the economy, where again the economy has yet to feel barely even half the impact of the rate hikes of the last 2 years. Economic growth is therefore set to weaken as the previous rate hikes bite, which should rein in inflation further, which makes us bullish of gilts.
Source: Macrobond, data as at 16/01/2024. Past performance does not predict future returns. AWE = average weekly earnings.
We had been long concerned that the surge in net gilt supply over the coming couple of years was not yet factored into the long end of the gilt market, where by ‘net’ we mean gross gilt supply adjusted for BoE purchases. Although the UK’s Debt Management Office (DMO) is unlikely to issue anywhere near as many gilts as during the crises of the past 15 years, the difference is that during prior recessions, the BoE mopped up this supply via its Quantitative Easing (QE) programme, leaving very little issuance for the private sector to take down.
This time around, the BoE is selling gilts too, where it is set to reduce its balance sheet by £100bn in the second year of Quantitative Tightening (QT), as bonds mature or are actively sold. The BoE bought these bonds at much lower yields, and while QE initially was a ‘profit’ for the Treasury department, the BoE estimated in July 2023 that the size of the mark to market losses from its QE programme were £150bn. Given the back up in the BoE base rate and gilt yields since this estimate, then it’s likely to now be closer to £200bn. That’s not to say that the Treasury suddenly needs to find £200bn – it only needs to underwrite realised losses on the QT programme plus the interest costs on the BoE’s assets (where these combined losses are so far £25bn). But in addition, QT pushes gilt yields higher, which increases the interest cost to the Treasury from when it needs to issue new gilts too. It is easy to see how things can get horribly circular, where higher gilt yields means bigger deficits, which leads to more gilt issuance, and so on.
It's hard to make a judgement call on when this ugly supply picture is priced in by markets, and we are not yet outright bullish on longer-dated gilts. However, 30-year gilt yields are now at 4.4% (at the time of writing, as of 12/01/24), where you need to go back 25 years prior to BoE independence for longer dated gilt yields to be materially higher than this, and we think a lot of the bad news around gilt supply is now priced in.
The chart below from Goldman Sachs paints a similar picture, where for the past decade, long-dated gilt yields have generally moved with net gilt supply (i.e., gross issuance minus net BoE purchases and reinvestments). The blue dotted line is an estimate of future supply, which is clearly liable to change. But longer-dated yields do appear to already be broadly reflecting the upcoming net supply, and therefore reflect close to fair value.
Source: Goldman Sachs. Goldman Sachs Market Strats. Data as of 22 December 2023. Past performance does not predict future returns. APF = the Bank of England’s Asset Purchase Facility.
To put a 4.4% yield on 30-year gilts into perspective, if bought today and held to maturity, then the nominal total return compounds up to 260% over the life of the bond. Contrast this to as recently as December 2021, when 30-year gilt yields were at 0.8%, which compounded to a total return of just 27% if the 30-year gilt yield was held to maturity.
Whether or not a 4.4% yield on a 30-year gilt ends up a good investment in the long-term will be largely down to where economic growth and inflation head in the long term, but even if UK CPI averages 3% over the next 30 years (and it has averaged +2.4% over the last 25 years), then we believe that a 4.4% nominal yield is not unattractive.
In summary, the supply picture does remain bleak for longer-dated gilts, however it is notable that the gilt curve has already steepened substantially versus other markets, so we believe that a lot of this bad news is now priced in. Consequently, we do not have a strong conviction view on the UK curve.
Source: Bloomberg, 01/01/1997 – 31/12/2023. Past performance does not predict future returns.
The performance track record of the Allianz Gilt Yield Fund indicates that our active management style and investment process has enabled us to outperform the benchmark on a repeatable basis.
The Allianz Gilt Yield Fund outperformed in 6 out of 8 calendar years and is up 1.73% net of fees versus the benchmark since Mike Riddell took over the management of the fund on 30th November 20152. Assuming fees of 7 basis points (bps) per year for a passive gilt fund, and that a passive fund perfectly tracks the index, then this implies outperformance of a passive gilt fund of about 2.29% over this period.
A key compelling reason for active gilt fund management in our view is the existence of several inefficiencies in the market creating opportunities for active managers:
Non-economic investors, which include central banks and insurance companies, make investment decisions based upon mandated guidelines, where objectives include book yield, currency management, or liability hedging. This means that they tend to be rather price insensitive.
The starkest example of an inefficiency caused by non-economic investors is seen in the inversion in the long end of the UK gilt curve, where the yield on a 50-year bond is considerably less than that on a 30 year bond. In contrast to the current inversion in the front-end of the yield curve, which is a late-cycle reflection of monetary policy, growth and inflation dynamics, the inversion in the long-end has structurally persisted for more than 10 years now. This primarily occurs because Liability-Driven Investors (LDI) such as insurance companies and pension funds require these assets to match their liabilities, and so will hold it despite having a lower yield.
Another major non-economic investor is the BoE, where BoE policy has created a large number of anomalies and distortions. The best example is the BoE’s QE programme causing move in relative value between individual gilts on the curve for eligibility and scarcity reasons. This also applies to QT, ie. the unwinding of QE.
We find that syndications of gilts can also present relative-value opportunities. As is normal with almost any debt issue, the increased supply of the gilt tends to negatively impact the price in the run up to issuance, in part due to the discount required to attract investors to buy the issue. Afterwards, this discount tends to be steadily removed, as its valuation normalises both relative to surrounding gilts, relative to other parts of the yield curve, and sometimes also relative to other countries’ bond markets.
Active managers can aim to generate outperformance through portfolio construction when the shape and level of the yield curve doesn’t reflect their expectation of the future profile of growth, inflation and monetary policy. They can increase (or decrease) the interest rate sensitivity relative to the index expecting falling (or rising) yields and over- and underweight different parts of the curve depending on their expectations on its future shape.
Relative value opportunities can also arise on a cross-market basis. Active managers can have the ability to invest in off-benchmark positions to capitalize on mispricings they have identified between different markets.
Finally, active managers can use derivatives, which can be a useful tool for portfolio positioning due to their precision and ability to take a short view. To take the Allianz Gilt Yield Fund as an example, the fund’s mandate allows us to use gilt futures in the portfolio to manage duration and to express yield curve views.3
By way of construction and following their mandate, passive funds do not have the ability to utilize the tools and to try to capitalize on opportunities outlined above. The mandate of an Index Tracker is to replicate the performance of an index as closely as possible. If a passive fund meets this objective, its performance after fees is likely to be slightly below the index over the longer term.
As demonstrated in the chart below, whilst the Allianz Gilt Yield Fund has taken active positions versus the benchmark, generating an outperformance since inception, passive funds in the sector tracking the FTSE Actuaries UK Gilts All Stocks index have underperformed the index over the same time period on a net of fees basis.
Source: Bloomberg, data as at 31/12/2023. The peer group consists of all index-trackers in the Investment Association (IA)’s UK Gilts sector (please see here for the current list of funds by sector) which are benchmarked against the FTSE Actuaries UK Gilts All Stocks index. Additional criteria include: competitor fund must have inception date before the selected period. Performance data must be available on Bloomberg. *) Please note that the Allianz Gilt Yield Fund is benchmarked against the midday priced version of the index whilst some index trackers are benchmarked against the end-of-day version. Institutional share classes have been used where available. Past performance does not predict future returns. The Allianz Gilt Yield Fund's benchmark is a target benchmark. This means that fund managers use the benchmark as a target for the fund’s performance to match or exceed.
In summary, we believe that for the first time in a long time, gilts are now offering reasonable value, and particularly out to around 15 years maturity. We are positioned bullish gilts accordingly across the funds that we manage, including Allianz Gilt Yield Fund.
In our view, the current market environment is offering substantial opportunities to generate alpha within an actively managed gilt fund, in terms of taking duration views, curve shape, cross market exposures, the attraction of front-end £ Sovereign and Supranational Agency (SSA) bonds, and ongoing relative value anomalies across the entire gilt curve. All of these factors give us encouragement that we can continue to add value versus the benchmark, and versus passive gilt alternatives.
1Please note that this is based on the Retail Price Index (RPI) which has historically been around 1%-point higher than the Consumer Price Index (CPI)
2Source: IDS GmbH, Allianz Gilt Yield Fund - I (Inc) - GBP, 30/11/2015 – 31/12/2023. Past performance does not predict future returns. Benchmark: FTSE Actuaries UK Conventional Gilts All Stocks Index Midday Total Return (in GBP). This fund's benchmark is a target benchmark. This means that fund managers use the benchmark as a target for the fund’s performance to match or exceed.
3The Fund may use derivative instruments such as futures, options, options on swaps and swap agreements (e.g. interest rate swaps). The Fund may use the derivative instruments listed above for hedging purposes and/or for investment purposes. For example, the Fund may use derivatives (which will be based only on underlying assets or sectors which are permitted under the investment policy of the Fund) (i) as a substitute for taking a position in the underlying asset where the ACD believes that a derivative exposure to the underlying asset represents better value than direct (physical) exposure (ii) to tailor the Fund’s interest rate exposure to the ACD’s outlook for interest rates and/or (iii) to gain an exposure to the composition and performance of a particular index (provided always that the Fund may not have an indirect exposure through an index to an instrument, issuer or currency to which it cannot have direct exposure).
