UK and US suffer in the reweighting game
Sunday 01 February 1998
KH: What is your outlook for government bonds over the next three months, and where are you investing now?
TB: In our global bond portfolios we have recently shifted from an overweight position in US and UK bonds and moved very heavily into European bonds, so they now comprise 60 per cent of our portfolios. The investment environment in Europe is benign, inflation is low, unemployment is high and interest rates are likely to come down a bit. Our decision to switch was based on our proprietary macroeconomic model which forecasts fair value yields in various markets and it has become less positive for the US and UK.
The German benchmark 10-year bond is yielding about 5.1 per cent. If you believe the dollar will be strong - as we do - you can hedge German investments into the US dollar and that gives you a hedging premium of 200 basis points, so the yield in dollar terms is 7 per cent and that is a lot better than the current 5.6 per cent yield on a US bond. So we use this technique of effectively creating synthetic US bonds.
KH: Why have you become more negative on US and UK bonds?
TB: Our models show the signal on the US has changed a lot. One of the factors we use is real yields, which is the yield after inflation has been subtracted. The real yield indicator has gone up, which is a signal that investors are demanding a higher return after inflation in that market because they may be concerned about inflation. That's the time to cut back exposure to that market.
Another factor we look at is the output gap - which is the difference between the potential GDP and actual GDP - and in the US and UK that output gap is closing, which is a sign of insufficient capacity that could lead to a rise in inflation.
KH: Are you relaxed about possible hiccups in European markets in the run-up to EMU?
TB: We think EMU is probably a done deal and we are already operating in a virtual EMU environment for investment strategy. We have about 40 per cent of our portfolio index weightings in the US and UK and the rest is concentrated in four main markets in Europe in roughly equal weightings. We have a position in Germany, which is a hedge against EMU going wrong. The remainder is in markets yielding 25 to 35 basis points more than Germany, in Spain, Italy and Denmark. If EMU goes ahead, it makes sense to invest in markets where there is scope for the yield spread with Germany to still contract.
KH: Have we seen the full impact of the Asian problems on bond markets?
TB: We haven't seen the full economic impact yet. Clearly it is beneficial to fixed-income investors because it will slow growth throughout the world. It will take time for the consequences to unfold but it will allow inflation in OECD countries to be lower as imports will be cheaper. That is why we are overweight in duration terms, pitched towards more risk on interest rates. If Asia gets worse and worse it will be better for fixed income instruments.
KH: What is your opinion of President Clinton's troubles?
TB: Historically Clinton's troubles never go away and yet never seem to go anywhere. This time my belief is that Clinton, who has played Houdini for several years, may not get out of the cage. Kenneth Starr is a very capable, deliberate man and he has spent three years planning his programme. If Clinton were to be forced from office that would have an negative impact on markets initially. People have taken the view that it could mean that the Asian rescue plan, which is important to the US, could falter and there would be less focus on the fiscal budget deficit which Clinton has brought under control as he inherited a strong economy. But Vice-President Al Gore, who would succeed him, has a good reputation in financial markets as being a very steady hand and would be respected by Wall Street. So the uncertainty would not last and the markets would respond positively.
I think the reason it is different for Clinton this time is because there is a legal angle here which would not be forgiven by the American people. It depends whether Starr can really make his charges stick, and we should know that fairly quickly.
Copyright: IOS & Bloomberg
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