Rates and Currency: Take A Long-Term View
Coverage of the 2012 Global Investment Conference.
BY Kenneth Barker | May 3, 2012
While there has been an increased awareness of the prevalence and dangers of short-termism in equity markets, there is perhaps less focus on the similar phenomenon in bond investment. Nevertheless, we calculate that the average holding period for a US treasury bond has fallen to 12 days. Indeed, if one adjusts for futures, this falls to an absurdly short two and a half hours. The results of this contraction in investment horizon are that market volatility has risen and economic planning is made harder.
While this phenomenon is investment bank-driven, a short-term approach to bonds has also affected asset management practices. This is perverse because academic research suggests that our predictive ability for interest rate and currency movements is extremely poor over short periods. While it cannot guarantee superior performance, we suggest that investing on the basis of sustainable trends in economics, politics and other social factors should provide a firmer foundation.
The Balassa-Samuelson Effect is a good example of longer-term trends. It theorises that developments in a country’s productivity will drive its real effective exchange rate as workers’ relative spending power improves. This tends to occur as a country industrialises and there have been several example in history such as Japan in the 1950s and ‘60s and South Korea more recently. If one can identify and follow a similar path then portfolios could be positioned to gain from exchange rate trends. The test is whether the country’s politics allow it to develop its potential without dissipating returns through high inflation.
In the past many emerging market countries failed to fulfil their potential because they were locked into vicious circles where volatile economic developments stymied reform of weak political institutions. The shock of the Asian crisis of 1998, however, led many countries to reform their approach, for example issuing bonds in domestic currencies rather than dollars. The subsequent growth in wealth has encouraged grass-roots support for political and economic reform and created a virtuous circle in some countries.
Political settlements – the combination of institutions and formal and informal practices in a country – are key to long-term economic developments. Consider the contrasting developments in Chile’s and the United States’ fiscal positions. Chile’s institutionalised fiscal conservatism, supported by a political consensus has seen debt and GDP ratios fall below 10%. In contrast the U.S.’s political conflicts and impasses have helped its deficit balloon.
Investors taking a longer-term approach should look for signs that political trends may take a helpful direction. Occasionally this will be baked in from the beginning. For example the robust approach to repaying state debts with federal money introduced by Alexander Hamilton. The first US Secretary to the Treasury established a creditor friendly approach that persisted for centuries. Sometimes a charismatic politician such as Deng Xiaoping in China or Lula da Silva in Brazil can change an economy’s course. Often, however, it takes a crisis such as Asia or Canada in the 1990s or Europe today to precipitate a change.
As a live example, global economic imbalances may be a source of bond and currency movements that persist for a considerable period, perhaps opening up investment possibilities. Developed economies must achieve competiveness and this may drive exchange rate appreciation in emerging market currencies. However there is a lingering tendency towards inflation in emerging markets despite reforms. This suggests that inflation-linked bonds may have merit, particularly since real yields are relatively high.
Kenneth Barker CFA is a partner with Baillie Gifford Overseas.