We think global debt is in a bubble: it keeps growing, year after year, without an equivalent increase in economic activity. Interest rates keep having to fall so that borrowers are able to service their liabilities.
As soon as central banks try to increase interest rates, debt weighs heavily on growth, sending inflation lower and forcing central banks to cut rates once more. There is a chance we are going through one of these cycles again, with the Fed probably hiking rates in December and the ECB thinking about tapering their bond purchases. However, any near-term increase in yields will probably be reversed in the coming months.
The big problems develop if we see sustained inflation from tight labour markets, or imported via a weak currency, forcing central banks to tighten policy even though economic growth is weak. Such ‘stagflation’ is traditionally bad news for bonds and risky asset classes. This scenario may eventually develop, but it is more of a tail risk today.
In our funds we still retain a bias to long duration given the backdrop of weak growth and low inflation, though we are tactically positioning for yields to rise in the very near term. More importantly, we are underweight credit risk given the negative implications of an over-indebted world for risky asset classes.
We still see adequate liquidity in order to be able to trade our funds as necessary to manage our portfolios. At LGIM, we focus on optimising liquidity in all its forms: primary, internal (crossing) on mutually beneficial terms for all funds (which is material due to the absolute size and mix of fund strategies and flows), buyside to buyside and secondary markets.
However, we remain concerned that financial repression is squeezing liquidity: this is another reason our portfolios are conservatively positioned with respect to credit risk.
Ben Bennett, head of Credit Strategy – Active Fixed Income, at Legal & General Investment Management