We are in the midst of a notable shift in the European economic policy debate; moving away from the uncompromising “austerity is the only path to growth” dictum to a more agreeable “austerity can go hand-in-hand with growth-promoting policies”. The truth of the matter is that “austerity vs. growth” has always been something of a false debate. They are not mutually exclusive. It is all a question of blending the right combination of factors into the policy mix; which of course is a very easy thing to say but rather difficult to do. Right now, governments of all persuasions face the dilemma of how to spur economic growth while keeping a tight rein on public expenditure.
Room for governments to manoeuvre on the fiscal side is extremely limited. Take the case of the UK government, which has already lengthened its fiscal consolidation plan by a couple of extra years but remains, rightly, very fearful that any additional relaxation of fiscal targets would weigh on its government bond yields. Inside the eurozone the situation is even more challenging; with countries such as Italy and Spain unable to even dare show any signs of fiscal relaxation on their own accord. Manoeuvring on the fiscal side proves a difficult process right now. This leaves the obvious, more immediate, option to act on the monetary side of the policy mix; something that international bodies such as the International Monetary Fund (IMF) are now openly advocating. Indeed, when the head of the IMF, Christine Lagarde, suggested that the Bank of England (BoE) should cut interest rates and engage in a further round of quantitative easing, while asking the UK government to prepare for a “plan B” (i.e. more relaxation) on the fiscal front if the additional monetary stimulus proves insufficient, she was simply acknowledging that markets are not ready to accept fiscal easing just yet. Going the ultra-easy way on monetary policy seems the best option in these troubled times. And, if this is the advice given to the UK, one can infer that it would also be the advice given to the eurozone. And so it is a “central banks to the rescue” scenario all over again.
A swift change in market expectations regarding economic policy may call for a rebalancing of your portfolio’s asset class mix. It is in situations like this where the flexibility of exchange-traded funds (ETFs) and exchange-traded products (ETPs) proves very useful. By virtue of regular on-exchange trading and pricing, ETPs afford investors the ability to act very quickly on a known price. If you are persuaded that monetary policy settings are highly likely to be loosened further, either by means of additional rate cuts or by virtue of extraordinary liquidity measures (e.g. quantitative easing in the case of the BoE, or more three-year LTROs in the case of the ECB), then you might want to consider rebalancing your fixed income exposure in order to increase your overall duration.
The price of fixed income holdings is inversely related to changes in interest rates. Duration – expressed in number of years – is the most commonly used measure of sensitivity of fixed income asset prices to those changes. From that it follows modified duration – expressed in percentage terms – measures the approximate change in a fixed income security price in response to a 100 basis points (i.e. 1.00%) change in interest rates. If you expect interest rates to come down, then you’d be better off holding longer-dated fixed income securities as their higher duration means that their price will increase proportionally much more than that of short duration securities.
ETPs could be a very efficient vehicle to engage in duration-management. Not only do they allow for quick portfolio rebalancing from a trading perspective, but they also allow investors to fine-tune market exposure, which is crucial when altering duration. Fixed income has been a key area of product development for ETP providers over the last couple of years and one of the examples is the array of funds offering investors exposure to specific maturity segments (e.g. 1-3y, 3-5y, 5-7y, 7-10y and so on). This “slicing and dicing” of overall fixed income market exposure – mainly eurozone and UK government, but also increasingly extended to other assets such as corporate debt – makes duration management a fairly straightforward task and one where the concept of core/satellite investing proves very useful.
In simple words, you can easily keep your exposure to the wider fixed income market in the “core” section of your portfolio and tactically use maturity-segmented fixed income ETFs to alter duration in the “satellite” section. By definition, the satellite section of a normal portfolio will be much smaller than the core, which helps reduce overall costs while achieving the desired investment goal, in this case altering the duration of your overall fixed income exposure.
