Global growth has peaked and investors should start to think about the potential for a slowdown towards the end of 2019, according to Schroder’s Michael Scott. 
The manager of the Schroder Strategic Bond fund said, however, that conditions for the time being remain favourable for bond investors in the credit sector.
As such, the FE Alpha Manager remains invested in a mixture of fixed income assets but is beginning to taper his high yield investments in favour of higher-quality bonds.
The main uncertainty in the fixed income space has been central bank monetary tightening and in particular how quickly the US Federal Reserve will raise rates.
Scott argued that the Fed’s hiking cycle is already priced into the forward curve – by which he means that the yield expectations on government bonds are broadly priced-in.
“Even in the event that interest rates continue rising, I think the expectations of this are fully-baked into the price and that is why you are not seeing significant falls in the value of bonds,” he said.
Indeed, while some fund managers have predicted that investors may make a negative return from bonds in 2018, the Bloomberg Barclays Global Aggregates index has risen by 3.78 per cent in sterling terms, year-to-date.
Performance of index over YTD
Source: FE Analytics
As well as a fully-priced US yield curve, bond investors have benefitted from tit-for-tat trade policies from president Donald Trump against the rest of the world.
While these tariffs have yet to have a material impact on equity markets – only a small degree of concern so far – there is the potential for this to accelerate.
Bonds tend to outperform during times of stress and any protectionist policies that appear to slow down the global economy could see investors pile back into the safer asset class.
With such negative news around, Scott said that the US economy likely peaked during the second quarter of this year, with the global economy peaking even earlier during the first quarter.
In theory, this should mean that equity markets begin to slow down, increasing the risk of a recession. In such a scenario, credit will underperform as companies begin to default – particularly at the higher yielding end of the market.
This is despite short-term fiscal measures employed by president Trump, such as tax relief and other fiscal policy stimulus, which have been aimed at extending the economic cycle in the US.
Scott said these measures will only have an impact for so long and will have come to an end by the time the next slowdown hits in 2020.
“That [fiscal policy] is clearly a very short shot in the arm, however I don’t think these policies do much for the supply side of the economy,” the Schroder Strategic Bond fund manager said.
He added that a Fed, which at the moment has no need to change its course on interest rates, will therefore continue its hiking cycle and continue to stifle the supply-side of the economy.
Federal Reserve dot plot of FOMC expected interest rates
Source: Federal Reserve
“My view would be that once these effects annualise it will be coupled with monetary tightening and an economy that has peaked and will start moving towards trend growth,” said the FE Alpha Manager.
“And as these factors start to play through then we could realistically see growth below-trend as we move into the back end of 2019.”
While he is not predicting anything as serious as the global financial crisis of 2007/8 – indeed he referred to this as a one-in-60 years event statistical anomaly – a slowdown would have an impact on investors.
“I don’t see the imbalances in the major economies for it to be anywhere near as severe as 2007, I am just saying that I think we could have a period of relative broad slowdown across the globe,” he said.
“I am not saying that it is this year or by mid-way 2019 but it will become clearer as we move through 2019.”
At this time, it may be that central banks have to reverse their tightening cycles and begin to cut interest rates again in an effort to bolster the economy.
“My view is the Fed will start cutting rates in 2020,” he explained. “Essentially, I think that we will start seeing a US-driven global slowdown from the back end of 2019. From what I see that is certainly not a consensus call,” Scott said.
As such, the fund manager has been upping the quality of his portfolio and purposefully allowing his high yield component to drift lower.
“We are not in a situation where we are solely interested in owning high quality assets in the fund, but I think I can make a case for the direction of travel towards that endgame over the next 12-18 months,” he said.
However, credit fundamentals still remain broadly positive across the board as they are more driven by company earnings than by interest rates.
One area he has been finding new ideas is in Europe, where he said that the credit cycle is one-to-two years behind where the US is.
“Arguably the credit fundamentals are stronger in Europe than in the US where we see higher degrees of leverage despite the stronger growth outlook. We feel that from a credit fundamentals and credit cycle perspective Europe is quite attractive,” he added.
Scott has managed the £143m Schroder Strategic Bond fund since September 2016, during which time it has been a top quartile performer, up by 7.69 per cent, more than double the IA Sterling Strategic Bond sector average.
Performance of fund vs sector since manager start
Source: FE Analytics
Its largest positions are in Spanish government bonds (5.9 per cent), with industrial and financials bonds dominating the top 10 holdings.
The fund has a yield of 4.01 per cent and a clean ongoing charges figure (OCF) of 0.79 per cent.