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Central banks are in an interest rate trap, warns Murray International’s Stout

04 September 2017

The investment trust manager outlines why interest rates cannot rise to normal levels without causing a recession and why he is looking to add more emerging markets exposure.

By Jonathan Jones,

Reporter, FE Trustnet

Investors need to embrace the “abnormal” environment as interest rates aren’t going back to normal levels, according to Murray International’s Bruce Stout. 

The manager of the £1.8bn investment trust said investing is extremely difficult at the moment thanks to ultra-loose monetary policies seen globally since the financial crisis.

Over the last decade central banks have enacted unprecedented measures, including quantitative easing and record-low interest rates, in an effort to pull the global economy out of the recession of 2008.

As the below chart shows, this has had an extraordinary on bonds, which have returned 123.7 per cent over the last decade, as measured by the Bloomberg Barclays Global Aggregates index.

Performance of indices over 10yrs

 

Source: FE Analytics

As such bond yields – which have an inverse relationship with the price – have fallen to historic levels, with UK 10-year gilts, for example, as low as 1 per cent.

But Stout said he does not expect this to change much in the future, as there is very little central banks can do to return the economic cycle to normality.

“If bond yields went to 4 per cent in the UK today then the UK would go into a depression because of the amount of debt in the system and if it did go into depression the bond yield would collapse to zero or minus,” the manager said.

“We’ve never had so much debt at the sovereign level or at the personal or household level. You name the level we have never had the piles of debt that we have today which means the whole global economy is much more sensitive to rates.

Away from the UK, the Federal Reserve in the US has been raising interest rates but Stout noted that four increases of 25 basis points over the last four years is not a normal interest rate hike cycle.

“So despite people trying to predict rates going up for the last four years and the futures market telling us for the last four years that rates in America were going to 3 per cent, they are not,” he added.



In fact, the manager questioned why central banks are even bothering to try and raise rates, given that none of the traditional reasons appear to be in place.

“What you have to say is that if you put interest rates up why are you putting rates up? You can put them up because they are too low, but they’ve been too low because apparently we have been in an emergency situation for eight to 10 years since the financial crisis,” he explained.

“An interest rate is just the price of money so if you put the price of money up then less people will use it. So it suggests you are going to squeeze consumption, which you will because that is what normally happens.

“They can talk as much as they like but the US and UK economy and all of Europe is based on consumption – it’s what drives them.”

The other reason central banks have raised interest rates in the past is to control inflation, but with levels remaining stubbornly low, the manager said this is not a problem either.

Latest inflation figures in the US showed prices rose by just 0.1 per cent to 1.7 per cent in July, while euro area annual inflation was lower at 1.3 per cent.

In the UK, Consumer Price Index (CPI) inflation was slightly higher with the annual rate at 2.7 per cent in July, though this was lower than many had anticipated given weaker sterling increasing import prices.

“In the past the reason you would put rates to 3 or 4 per cent would be to cool down sectors of the economy that were overheating or most importantly to rein in inflation - and inflation would be because it was in the labour market,” Stout said.

Performance of UK CPI over 10yrs

 

Source: Office for National Statistics

“Inflation isn’t in the labour market at the moment, it is in some pricing, but there is no way it is of any threat to anybody because when there is excess capacity and excess debt around the world then by definition it is deflationary not inflationary.

“So why would you jack up rates to 3 or 4 per cent if there is no real inflationary threat either in prices or labour markets – there is no justification for it.”

Stout added that some could argue central banks have to raise rates to normalise the cycle but he questioned what ‘normality’ meant in the current environment.

“’Normal’ in the context of 20 years ago: when we had a normal relationship between bonds, equities, yield curves, positive real returns in banks etc. I don’t see any of these relationships prevailing at the moment, so what is normal in this environment?” the manager asked.

“I don’t know what is normal. It has been abnormal for so long. People crave normality because that is recognisable and therefore comfortable but it doesn’t prevail.

“So we are going to have to deal with what’s in front of us, not what we would like it to be and what is in front of us is mountains of debt in all areas of society and that is not conducive towards growth and stability and a positive outcome.

“Central banks are in a deflationary monetary trap of their own making. They have made the trap and we are snared in it. Don’t ask me how they get out of it,” he added.



“I don’t know how they get out of it and they don’t know how they get out of it either but it makes investing very difficult because you are trying to price asset prices off some kind of yardstick.”

With many yardsticks such as price-to-book and price-to-earnings disturbed by the eye-watering valuations of some companies in the developed world, the manager is therefore focusing his attention to the emerging markets.

“It is a lot easier to identify normal relationships in the emerging world than it is in the developed world because they don’t have all the debt,” said the manager.

“They have regular type yield curves that go from short rates being at a low level and longer rates being higher so there is a curve there.

“You can put money in a bank in the emerging markets and get a positive return on your savings you don’t pay the bank to look after it for you the way we do.”

His fund is 24.4 per cent invested in Asia ex Japan equities and 16.7 per cent in Latin America and other emerging market equities.

Interestingly, the fund is also around 20 per cent invested in emerging market debt, which the manager initially invested in in 2014 and added to throughout 2015.

Performance of index over 5yrs

 

Source: FE Analytics

“We had a sharp selloff in all currencies of emerging markets. Some incredibly sold-off such as the South African rand which went from 12-24 against the dollar or the Brazilian Real which went from 1.6 to the dollar to 4,” said Stout.

“They became very cheap and at the same time emerging market debt sold off because people thought the emerging markets were finished.

“That was the logic behind building up that position and that then de-gears the trust such that today it is only 91 per cent geared into equities, which means there is 20 per cent in bonds - that’s the lowest equity gearing we have had since 2007.”

He added: “The reason we are quite happy to maintain those bond positions is that we have a fundamental point of view that there are still a lot of improvements coming through in places like Indonesia, India, Mexico and even Brazil – inflation has collapsed there so there is still plenty of scope for rates to come down.

“We believe we can still have some yield compression on these bonds and can still have some currency uplift because a lot of the currencies although they’ve bounced a bit the fundamentals are much stronger in these countries because they have sorted out their imbalances.”

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