Holly Cook: Welcome to the Morningstar series, "Why should I invest with you?" To answer that question joining me is Gareth Isaac, he is the Manager of the Schroder Strategic Bond Fund.
Gareth, thanks for joining me.
Gareth Isaac: Hi.
Cook: So why don't you try and give us sort of lay of the land of the area that you are investing in. What kind of thing keeps you awake at night? What are your main concerns?
Isaac: Okay. Well we have three main concerns at the moment. And the first one is a repeat of what we saw during the summer of last year following Mr. Bernanke's decision to discuss tapering of the US QE programme. Our central view is that the US economy is improving, and the slowdown we have seen in Q1 has been more to do with sort of seasonal and weather-related incidents rather than a genuine slowdown in the economy.
We do think the US is going to begin to grow more strongly as we go through 2014 and that employment growth will be strong and wages are going to start to increase. We think the markets are being slightly too sanguine with regard to future interest rate expectations and the timing of the first rate hike. And as we do see an improvement in the US, we think the market will bring that forward and we will see another period of volatility. We don’t think it will be as bad as it was last summer. But we do think that there will be a period of volatility.
And the market is quite heavily invested in asset classes which are slightly more risk positive, and we do think that as investors try and move out of that, there may be a scramble for the door and you will see continued volatility throughout the market.
Cook: I can't let you say that without asking you, when do you think the first interest rate hike is going to be?
Isaac: Well, I think that if the path of employment growth that we expect to see comes to fruition, we think it will be perhaps late this year or early 2015. Bond yields have rallied pretty aggressively over the last two or three weeks and we do think that it's difficult to see them as particularly good value. So as you do see a normalisation we think of the bond market, that will cause a period of volatility.
Cook: And sorry for interrupting you, please go on with your other concerns.
Isaac: Yes and the other two. The first one is China. There has been a lot of speculation in the press, I mean we read about it every day that there has been a huge credit growth within China and that's starting to deflate. We are starting to see bankruptcies within the Chinese economy. That actually is possibly quite a good sign that there is a normalisation in the credit markets there and that companies are being allowed to fail.
However, with the recent surge in credit expansion there, it's going to be quite difficult to deflate that bubble without causing significant damage to the economy. The Chinese economy is very different to most other economies, it does have a very, very large reserve balance of US$3.5 trillion-plus to help it through that. It is command-style economy and it has no external debt. So it isn't quite the same as it would be, if it was a slightly more Western-leaning country, but there are concerns there and that's something we do keep an eye on.
Also we are quite concerned about the outlook for the European bond markets. I was always quite a strong advocate of buying peripheral debt in 2012 and '13, but I do think spreads have come in a little bit too much there. Also we are seeing very, very low inflation output in Europe and the output gaps there are quite large. And we expect to see that to continue.
There is some reluctance from the ECB to take on more unconventional measures and we do think that against that backdrop, inflation remained very low, nominal growth despite the cyclical upswing will remain quite low. And too low to be able to make the debt profiles sustainable.
The main problem with that is, is that, if there was an exogenous shock of any description, central banks are going into this with very, very high debt-to-GDP, high deficits and governments aren't able to provide any stimulus through lower taxes or increased spending. So that's one thing, the main thing I guess that worries us at the moment.
Cook: So very little room for manoeuver there. These are some quite major concerns. What kind of steps can you take to mitigate these risks?
Isaac: Well, we have reduced risk fairly dramatically over the last sort of three to six months. We have reduced our high-yield exposure to some specific idiosyncratic names. We have also reduced the duration on the fund and the credit allocation as a whole. We built up around 15% in cash. We will continue to increase that cash balance through Q2 in expectation that we get a better area – well, a better level to invest towards the second half of the year.
Cook: So with that cash balance in the second half of the year, where do you see the most interesting opportunities to be putting that to use?
Isaac: Well, we still think that default rates are going to remain particularly low in Europe, purely because interest rates are likely to remain low for a considerable amount of time, far lower than they are in the UK or in the US. Europe is still going through a deleveraging process, which means that credit there and high yield still offers some value. But we do think we will be able to re-enter those markets at better levels in the second half or more towards Q4.
Cook: Well Gareth Isaac for Schroders, thanks very much for explaining that to us.
Isaac: Okay. You are welcome.
Cook: For Morningstar, I'm Holly Cook. Thanks for watching.
