20th October 2010

Investing in fixed income if quantitative easing resumes

There have been recent proposals in the UK to resume quantitative easing, following concerns that the UK economy is slowing and could enter a “double-dip” recession. John Anderson, Head of Credit at Gartmore, is unsure whether the resumption of quantitative easing is the best course of action to protect the UK’s fragile economic growth: “There is a danger that quantitative easing could prove inflationary, which is not ideal given that the UK is already suffering a persistent level of above target inflation”.

Although John does not believe the UK economy will experience a “double-dip” recession, he acknowledges economic growth will remain subdued, partly due to the government’s proposed austerity measures. He believes that the proposed budget cuts could dampen future economic growth, which will place pressure on the Monetary Policy Committee not to raise interest rates. If interest rates continue to persist at their current low levels, this could push UK inflation even higher.

In terms of how John is positioned, he has taken measures to reduce his exposure to UK gilts, which he believes are already pricing in slowing economic growth and a resumption of quantitative easing:

“In recent months we have seen gilt yields fall due to a flight to quality at the short-end, while at the long-end, yields are reflecting concerns over slowing economic growth. In August, yields on 10-year gilts actually dipped below three percent; a historic low point for the market. A resumption of quantitative easing will create an additional source of demand as the Bank of England buys back gilts, placing further downward pressure on yields. In this environment it is very difficult to find value within the gilt market”.

John believes that low interest rates have already saturated the gilt market with high levels of liquidity, forcing investors to use the gilt market to place surplus cash, underpinning yields. As a result, investors now appear willing to search for higher yields in the corporate bond markets:

“Many investors, including myself, are now happy to take on some additional risk, investing in higher yielding corporate bonds lower down the rating scale. This is unsurprising because despite a gloomy macroeconomic environment, corporate fundamentals are actually quite strong. Many companies are already exhibiting strengthening balance sheets, strong cash flows and positive business outlooks for the year ahead.”

Over the last couple of months, John has been increasing his exposure to lower quality investment grade and high yield issues. Looking forward, he believes that this is where value will be found.

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