Last week, Morningstar ran our annual investment conference, on subjects ranging from Brexit and risk management to the cost of funds and the future of advice. Read on for our coverage of the Morningstar Investment Conference UK in our special report: What the Experts Say.
Emma Wall: Hello, and welcome to Morningstar. I'm Emma Wall and I'm joined today by Jim Leaviss, Head of Fixed Income for M&G.
Hi, Jim.
Jim Leaviss: Hello.
Wall: So, it's challenging bond buying environment in Europe at the moment and part of that is due to negative interest rates, isn't it? What are the consequences of the ECB and indeed, the Bank of Japan, having negative interest rates?
Leaviss: Yeah, we've got negative interest rates all over Europe effectively now from Switzerland, Denmark, Europe and as you say, Japan. I think there are some big problems with negative rates that perhaps central banks are only now realising to maybe put a floor on how negative they can go. I think about people taking money out and storing under mattresses or in a safe and you see even big insurance companies in Germany doing that. The ECB has abolished the €500 note to try and stop this kind of behaviour, although they have said it's really about tax avoidance, but we know what it's really about.
And it also has a lots of other implications such as in Switzerland the taxman has even asked taxpayers not to pay their bills on time because they don't know what to do with the money. It's going to cost them to keep it in the bank. And finally, I think it really hurts banks' profits and for me, that's the real big problem with negative interest rates – that banks are simply unable to pass on those negative rates to depositors.
They know that they will just take their money out of their bank accounts and put it under the mattress. So, as a result, you've seen in Switzerland that mortgage rates have gone up, the more negative the Swiss National Bank has set interest rates. So, a lots of problems that in a world where cash exists, people can run away from negative interest rates and that probably puts a lower limit on what they can do in terms of how negative they can go.
Wall: And of course, negative interest was supposed to stimulate the economy. But you're saying that because of course so much economic growth is driven by consumer growth and if it's having a negative impact on the consumer through things like mortgage rates, actually it's going to end up doing the opposite of what it intended to do.
Leaviss: Yeah, and not just the higher mortgage rates we're seeing in Switzerland, but the other factor that people haven't really thought about enough is; what is the psychology of negative rates? If you are a central bank and you are setting negative rates for the first time in history, does that encourage you perhaps – it's meant to make you take your money out of your bank account and go and buy some stuff because it's better to own stuff than lose some money in your bank account.
In fact, evidence so far might suggest that it encourages people to save more money even at zero or lower because the signal from central banks is: “Oh my god, things are terrible, we're in a negative rate world”. And so, you get these perverse behavioural things going on as well that means that we're not seeing any great animal spirits emerge in Europe or elsewhere as a result of negative rates.
Wall: And of course, negative rates is not the only lever which they have pulled in Europe. The ECB is now buying corporate bonds. Maybe you can explain a bit more about the intention of that message.
Leaviss: Yeah, I mean, they announced on the 10th of March a part of Draghi's big bazooka approach. So they are going to start buying, who knows, €5 billion, €10 billion worth of investment-grade European corporate bonds every month. For those of us around in '08-'09 when the Bank of England started doing this, it had a tremendous power to drive corporate bond prices higher and I expect that to happen.
It's going to really benefit BBB-rated bonds; it's going to benefit French bonds in particular because there's more of those in the buying basket.
The question is, do these companies really need the money? I think the answer is for most of them that's not the case. But you should have some trickledown effect where me as an investor sells my corporate bonds to the ECB and I've got some cash. I go and buy something a bit more risky, a high-yield bond or I go overseas to the U.S. where the U.S. BBB market looks really, really cheap at the moment and maybe that depresses the euro. So, it can have some not-direct impact, but maybe it's a second round impact, that may produce some impact for the European economy.
Wall: And of course, it's music to your ears as a bond investor because for quite some time people have been saying, oh, cash in bonds; the bond rally is over. But actually, here is another tailwind for the fixed income market.
Leaviss: Yeah, I mean, people have been saying cash in your bonds for about 30 years now and yields growing lower and lower and lower. For all it's worth, I think, we probably are near the end of that process than the beginning. But I think that there's still a great deal of demand for income around the world and I think there's still a big underpinning for the credit markets.
And the corporate bond markets are pricing in a huge number of defaults. If you go back over the past 50 years, the average default rate for a BBB-rated bond is 0.4% per year. The market is pricing in 4% per year in the U.S. which just looks like ridiculous that you're like to get 10% more defaults than on average in what's a relatively decent economy in the United States right now. So value there.
Wall: And of course, because you're diversified, you can afford to take these plays?
Leaviss: Yeah, I think you need to be.
Wall: Jim, thank you very much.
Leaviss: Thank you.
Wall: This is Emma Wall for Morningstar. Thank you for watching.
