Harsh medicine

If there’s one thing investors can learn from bond markets today, it’s that the world has changed. Throwing free money at our problems may have seemed like the right approach post-2008, but it’s no cure for surging inflation; nor will it heal deep-rooted, systemic problems like high debt/GDP ratios or climate change.

The diagnosis, in a nutshell

On the one hand, there’s the question of what to do when surging inflation comes along as it has done in 2022. As the cooler weather pushes thoughts of record-breaking heat waves to the back of people’s minds and pulls the cost-of-living crisis to the fore, both elected people pleasers and unelected technocrats have difficult decisions to make.

On the other hand, there’s the ‘big’ question that asks what central banks should do about climate change. It matters because they are gargantuan holders of bonds—courtesy of the auspiciously named ‘quantitative easing’ experiments (bond buying) that’s occurred since 2008. It should come as no surprise that the lids have been lifted on those bond portfolios and the contents have been found wanting. Fossil fuel and industrial companies typically need more debt than ‘cleaner, greener’ technology companies.

‘Gilty’ consciences and canaries

What happened recently in the UK government bond (gilt) fiasco serves as a canary in the coalmine for the rest of the financial system. Bond markets are highly sensitive to changes in currency fluctuations, inflation expectations and economic growth. The gilt event destabilised all three, resulting in the fastest policy U-turn by a UK government in its first month on the job.

The misguided fiscal intervention by now ex-new Prime Minister Liz Truss and her (now ex) finance minister Kwasi Kwarteng aimed to boost economic growth by cutting top earners’ taxes. The market response sent sterling reeling and UK gilt markets sank in value. A few days of chaos were enough for the Bank of England to intervene.

Monetary and fiscal policies need to work in tandem in order to achieve financial stability. If they don’t, this increases the risk of a phenomenon I call a ‘monetary-fiscal feedback loop’. This happens when supportive fiscal policy partially offsets a tighter monetary policy. As consumers find themselves in a weaker position given the higher food & energy prices governments are inclined to go the path of least resistance, or better: highest degree of popularity, and announce their supportive measures. While it screens intuitive to support your people when needed the disadvantageous side-effects may dominate the benefits. In fact, the fiscal measures strengthen the position of the consumers while a weaker consumer is needed to keep core inflation in check. Central Banks have no other choice than rising rates as long as core inflation is elevated as their credibility is at stake which in turn weakens consumers (higher mortgage costs etc.). There is a real risk that this fiscal-monetary ping-pong continues until people accept the pain of higher rates in combination with waiving fiscal support, as a newly-inked article in The Economist put, 'it would be a mistake to accumulate debts simply in order to put off hard choices, using up fiscal space that may be needed in future crises—not just climate change, but also unforeseen disasters such as pandemics.' In addition, fiscal stimulus leads to additional government bond supply right at the time where central banks have stopped buying. Hence, 'economic' buyers have to step in and they demand a higher compensation for the risk they are taking. 'Bond Vigilantes' are back in town.

The crisis school of management

Believe it or not, these are exciting times for active bond investors—the entrepreneurs and adventurers amongst us know that crises breed opportunities.

For one (simple) thing, price declines mean there’s higher upside potential from here. For myself and my team, the question I ask myself is, how we can accelerate performance by steering through today’s pain and maximising upside potential whilst staying true to the philosophy we instil at Cape Capital?

Yes, it is possible to be bullish on the fixed income asset class in a recessionary environment if you select the right securities whose future expectations are bright. This requires a close eye on fundamentals, the regulatory environment and playing to the team’s niche expertise.

Which issuers will likely express resilience through these tricky times? Those will be the quality companies with strong balance sheets and cash flows —the higher quality credit issuers whose names you would recognise and support. Moving down the capital structure of high-quality issuers and investing in the subordinated bonds to achieve a ‘sweet spot’ higher risk/return profile is another hunting ground of opportunity.

Aside from being an opportunist, it is vital to be a student in a crisis—so what should investors learn from this one?

Pain, peanuts and perspectives

The world has changed and economic sirens are ringing as central banks keep tightening monetary policy until something cracks. Indeed, it needs to. Meanwhile, we seem to be facing insurmountable systemic issues such as inflation, geopolitical turmoil, climate change, inequality and more.

The question I raised earlier, on what central banks should do about climate change whilst inflation rages on, needs answering. Critics recently accused the ECB’s new green shift as ‘a distraction’ from their core task of maintaining stable prices and their intention to decarbonise the central bank’s bond portfolio as mere 'peanuts'.

Yet, as the UK shows, radical swings can be dangerous and irresponsible when the global financial system hangs on a thread. If we are to demand central banks to take more action on climate change, then they should do so with extreme caution and with their primary mandate of stabilising prices at the fore—change is a process, not an event.

My last lesson to investors then is one of perspective. Pain is coming, but it need not be unwelcome. When I was a younger man, I liked to travel long distances by bicycle. I remember one trip from Zurich to the North Cape, Norway. Riding for eight or nine hours every day gives you a lot of time to think (especially in the latter days when the lactic build up was real). I started to calculate how many times I had to press the pedal to get to 4000km and unsurprisingly my calculation lead to an extremely high number which made the distance feel even bigger. So, one cycle, let's say 10m, looks like 'peanuts'.

You can then think about how many peanuts in a row would be between Zurich and the North Cape—I would say one peanut is probably two centimetres, so that means, for 4000 kilometres, roughly 200 million peanuts lined up on the road. If you visualise that in front of you, that’s a huge challenge.

But, in turn, if one peanut is roughly two cubic centimetres of volume and then I take all the peanuts on the road between Zurich and the North Cape, group them all together into one cube and look at it, it’s not that big, it’s just one big house full of peanuts—that’s it.

It's just a different perspective.

This story has a link to the challenge that’s levelling in today’s financial market and especially in fixed income. Fixed income is not the asset class that makes huge steps. It is an asset class characterised by graduality, repetition and certainty—very similar to a long bicycle trip.

I managed to go to the North Cape based on the above principle. My advice to investors then is to step back and see these insurmountable problems through this different perspective until they don’t only look manageable, but more like opportunities for change.

My hope is that financial actors everywhere, including central banks, governments, investors and predominantly politicians with an average legislature shorter than the average bond duration to tackle their various challenges in this way—counting the peanuts one at a time and remembering the long-term goal that makes the pain worthwhile.