Risks that aren’t priced in can be much more dangerous than widely anticipated problems. Investors can avoid sell-offs that have been well signposted by shifting their exposure ahead of time, whereas unexpected events catch people out.
One risk that investors may not appreciate is the potential for increased borrowing costs to plunge the UK into a deep recession next year. If homeowners are forced to remortgage and businesses to borrow at much higher rates, and if this all happens at the same time, the UK could experience a more severe recession than people expect.
For central banks, using rate hikes to put the breaks on inflation is an inexact science and therein lies the problem, according to Jim Leaviss, chief investment officer of fixed income at M&G Investments.
“Monetary policy works with a lag, like a steam train,” he explained. “You pile on coal into the engine and then you put the breaks on and it takes a long time to slow down, it’s not like putting the breaks on in a car.
“Thomas the tank engine will teach you everything you need to know about central banks.”
Increased borrowing costs might not be felt by households and businesses for six to 24 months after the relevant central bank raises rates. “These lags make it very hard for central bankers,” Leaviss said.
“The risk is that 500 basis points of cuts are all felt at once, which could lead to a deep recession. I think that, for me, is the biggest risk,” he continued. “Obviously I hope that doesn’t happen.”
Another cloud on the horizon is whether there will be sufficient buyers of US Treasuries now that the Federal Reserve has stepped back and ended quantitative easing (QE).
“Nobody has worried for the past 18 years about who is going to buy government bonds. It’s been the Fed and other central banks,” Leaviss said. “QE started in 2008 after the global financial crisis, then there was more QE in the euro zone debt crisis and [again during] Covid. That has stopped. The biggest buyer of government bonds has gone away.
“At the same time, government borrowing has increased relentlessly in the past few years and will continue to increase,” he said, due to ageing populations and increased spending on healthcare and pensions.
Despite these supply and demand concerns, Leaviss’ strongest conviction is that “it is time to buy government bonds”. He has been buying long- and short-dated gilts, bunds and Treasuries.
Since the end of the 1960s, whenever the US Federal Reserve has stopped hiking rates, it has reversed course quite quickly and started cutting about eight months after the last hike. By that yardstick, the Fed should start cutting in mid-2024, Leaviss noted.
The reversal of quantitative tightening should lead to a significant rally in US Treasuries and gilts. If the yield on a 10-year government bond falls by 1%, there should be a 7% capital gain, Leaviss explained, because price and yield have an inverse relationship.
“Having seen capital losses this year, history tells us that we will get gains next year.”
Leaviss has reduced his exposure to investment grade corporate bonds as spreads have tightened and he does not own any high yield bonds. “When spreads tighten, we are disciplined at trying to sell credit,” he said. “I am hopeful that when the next blow up happens, we won’t own any corporate bonds.”
Although M&G has reduced its exposure to risk assets, it still has around 15% in emerging market debt. “Yields look really attractive,” Leaviss observed, and demographic trends are favourable. “Emerging market fundamentals aren’t in a terrible place. Their central banks are more anti-inflation than developed market central banks.”