BLOG: Three reasons to be cheerful in a low-growth world

Written by: Lloyd Harris
Low inflation, low default rates for investment grade fixed income, and the lower likelihood of a hike in interest rates, all spell a sweet spot for high quality corporate bonds says Old Mutual’s Lloyd Harris.

There is a strange contrast between the nervous mood in the stock market and what is felt by the person in the street. Markets have been reassessing their expectations for economic growth, which has caused volatility in risk assets. Meanwhile, ordinary men and women have been enjoying lower petrol prices, lower mortgages, and cheaper groceries.

The nervousness of the stock markets has hit the headlines, but don’t be fooled: the UK is not about to enter a recession, in my view. What has happened is that markets have had to adjust their thinking.

When this year began, the market price of assets was founded on expectations of a stronger growth environment. Those foundations now look shaky. We now know that growth is going to be weaker than was initially thought.

This is not the end of the world. And for investment grade bond investors, it is in fact a good thing. While corporate defaults are rising for lower grade, high yield bonds, investment grade bonds are relatively safe. In a low but positive growth environment, default rates on investment grade bonds are likely to remain extremely modest.

It now seems likely that economic growth will not be strong enough to warrant policy interest rate rises in the UK any time soon. This too helps the bond market, as interest rate hikes would have threatened bond prices. I believe the Bank of England will raise interest rates either once at most or not at all this year.

Cash in your pocket

Meanwhile, the man and woman in the street are feeling pretty good. Petrol prices are cheaper. Two years ago it cost me £100 to fill the tank of my car. Now it costs me only £65 – that’s what a lower oil price does for you.

Mortgage costs have come down. Two years ago, a fixed-rate mortgage with a 40% deposit cost 2.91% on average. Now it costs only 1.99%. So those resetting their mortgages after two years are £60 better off a month.

The weekly shop is also less expensive. I started using Aldi and Lidl instead of Tesco a couple of years ago, when I realised they were not only cheaper but the food was of better quality. I also noticed my local Tesco car park was only about 10% full, but that the Aldi and Lidl car parks were packed. The writing was on the wall for the UK supermarkets back then. According to The Grocer, a sample basket of groceries in Aldi was 30% cheaper than Sainsbury’s: that’s typically a saving of about £20 a week.

Cheap petrol, less expensive mortgages, and cheaper food prices are putting cash into the pockets of ordinary people. All three are examples of deflationary pressures. The worst enemy of bond investors is inflation, because a bond pays a fixed income that will be worth less in real terms if inflation rises. Inflation, as measured by the Consumer Prices Index, in the UK was only 0.2% in the year to December 2015, another reason why the outlook for bonds is healthy.

We have positioned our portfolios to benefit from these factors. As people have a little more disposable income because of lower fuel, food and mortgage costs, it is no coincidence that new car registrations were at an all-time high in 2015. Our fund is overweight in auto manufactures and auto-parts manufacturers.

Another sector I like is UK banks. Their asset quality is strong, and the default rates on their loan books are low because of the healthier finances of UK households. The strong regulatory environment, which I am sure Andrew Bailey, the new chief executive of the Financial Conduct Authority will continue, has been very helpful.

Bonds investors like banks to be strongly regulated, because it leads to strong bank balance sheets. We call it cheap but tight money: cheap because interest rates are low, and tight because regulation is strong. We hold bonds in Lloyds Banking Group and Nationwide, both names at the heart of the UK housing market.

Unfortunately Aldi and Lidl do not issue corporate bonds, but in view of the effect of their rapid growth on incumbent UK supermarkets we have been underweight in the sector for some time.

So, with the average UK household now £200 per month better off because of these three factors alone, and with a continuance of a low-growth, low-inflation environment, in my view it is worth being exposed to these trends in a form that benefits most from this environment: high quality investment grade corporate bonds.

Lloyd Harris is manager of the Old Mutual Corporate Bond fund


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