JP’s Journal: Awaiting the cut

An article on the growth of passive investment caught my attention last week. Despite being an advocate of active management, I can see that there is a role for index investing.

It can provide cheap exposure to asset classes where active strategies have failed to add value. In my mind, the US equity market is such an example, where managers have found it difficult to outperform. There is also a general assumption that government market indices are difficult to beat. Conversely, credit is seen as a fertile hunting ground for active approaches.

The analysis in the article confirms some assumptions but not others. In general, equity managers have struggled. According to S&P, over a 10-year period to end June 2023, 95% of global equity mutual funds have failed to beat their indices and a similar percentage of UK government bond funds have underperformed. Both are higher than my expectations but confirm the general view. Where my views are challenged is in relation to sterling corporate bonds. It seems that active managers are also struggling. Indeed, when looked at over a five-year period, the asset class has the lowest percentage of funds that have consistently outperformed on an annual basis. Now, I think looking at consistency of annual performance to judge a long-term record misses the bigger picture, but the data challenges my “it’s easier to outperform in credit than equity” mantra.

All this may sound defeatist, coming from an active manager. But, in time honoured tradition, there is another way of looking at things that is more positive. The harder it is to outperform in an asset class the more recognition should be given to those that do deliver. In no particular order, what has been achieved by Royal London Asset Management in global equities, government bonds and sterling credit is worthy of closer examination. Yes, I am blowing our trumpet but the numbers speak louder.

On the news front, the US Federal Reserve took centre stage last week. As expected, they decided to keep the target range for the Fed Funds rate unchanged at 5.25 to 5.5% and the median rate projection was maintained, indicating 75 basis points (bps) of cuts through 2024. However, there was an upward revision to 2025 and 2026 rate projections and a 10bps increase in the long-run rate estimate to 2.6%. Melanie Baker, our Economist, thinks there are three cuts coming this year but the inflation data will be key.

The Fed overshadowed the Bank of Japan’s (BoJ) decision to end its eight years of negative interest rates. Despite signs of rising wage pressures, investors remain relaxed about the inflation outlook and 10-year Japanese government bond yields finished lower on the week. It looks likely that the BoJ will provide less support to the market and we could see yields drift higher in coming months. This may provide a challenge to bonds as the monetary stance in Japan has provided considerable help to global markets.

The Bank of England kept rates at 5.25% but there was a shift in the votes, with two moving from favouring a hike to no change. Governor Bailey indicated that a rate cut was on the cards – but not yet. The majority felt that both wage growth and service price inflation were too high to justify an immediate move but a cut before the end of June is now a distinct possibility. Yields on 10-year gilt responded positively, falling 18bps on the week, closing just above 3.9%. With US 10-year treasuries  at 4.2%, this represents a yield differential around 0.3%, the widest seen this year. Euro markets also saw lower yields with the German 10-year at 2.3%. There was a widening in the Italy-German spread, but the theme this year has been of Italian outperformance.

Credit markets continued to perform well with spreads staying around 12-month lows. The differential between BBB and B rated credits has now returned to the levels seen before the Great Financial Crisis. For medium-term investors, we still favour investment credit over government bonds, particularly at shorter maturities. But valuations in high yield reflect a benign consensus that may not materialise. Overall, an environment for the skilled active manager.

This is a financial promotion and is not investment advice. Past performance is not a guide to future performance. The value of investments and any income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice.