Central Banks Key for Scottish Funds as Economies Diverge

As economies diverge, the message from strategists at Scotland’s two largest fund management companies is simple: just follow the central bank.

The prospect of further action by the European Central Bank as the euro region’s economy risks sliding into deflation has led to returns on government bonds this year that are more than twice those in the U.S., where the Federal Reserve is reeling in stimulus. In the U.K., the pound beat all but one of nine developed-country peers in the past year as investors wait for the Bank of England to raise interest rates.

“A lot of investors are looking at these different views of central banks and placing currency and short-term bond bets accordingly,” Andrew Milligan, head of strategy at Standard Life Investments, said in an interview in Edinburgh last week. “It’s a good tactical trade.”

The average yield to maturity on euro-area government bonds fell to an all-time low of 1.30 percent on June 26, according to Bank of America Merrill Lynch’s Euro Government Index. That’s down from 4.93 percent in 2008.

Spanish 10-year yields have dropped more than 5 percentage points since reaching a euro-era high of 7.75 percent in July 2012. At 2.85 percent today, the Italian yield is down from 7.48 percent less than three years ago.

Healing Money

Standard Life Investments favors European government bonds instead of U.S. Treasuries and U.K. gilts, Milligan said. Richard Dunbar, investment director at Aberdeen Asset Management Plc, said he prefers high-yield corporate bonds.

Aberdeen Asset and Standard Life Investments oversee about $860 billion of assets between them.

“Some European bond markets are trading at yields that have surprised,” Dunbar said at the same discussion at Bloomberg’s Edinburgh office. “At the end of the day, you can debate whether those are the right or wrong prices, but these countries can borrow at these prices. Every day that goes by, it has a real impact on their real economy.”

For Milligan, the ECB President Mario Draghi’s policy priority is to nurture that recovery and that means government bonds in the region will continue to be supported.

World Beaters

“We are still happy to hold European government bond assets on the grounds that we are still seeing some countries like France and Italy where the growth figures are reversing again,” said Milligan. “We would still see it as eminently possible that they have to follow up with some form of quantitative easing in 2015.”

Euro-area securities have returned 7.2 percent this year through yesterday, Bloomberg World Bond Indexes show. That compared with 3.3 percent for Treasuries and 3.4 percent for U.K. gilts. Among the European markets, Greek and Portuguese bonds led the way with gains of 29 percent and 15 percent.

Spanish five-year notes yielded 36 basis points less than U.S. Treasuries with a similar maturity at the end of last week. That marked a turnaround from the height of the sovereign debt crisis in July 2012, when investors received an extra 705 basis points to hold the Spanish debt.

Italy’s borrowing costs have fallen to new lows, while its debt is rising to the most ever.

“Maybe Spanish bonds shouldn’t be below those on U.S. Treasuries but the fact is they are and that is helpful and healing,” said Dunbar, who joined Aberdeen after it agreed to acquire Edinburgh-based Scottish Widows Investment Partnership last year. “That’s a real benefit.”

Bond Returns

The euro region economy will underperform its Group-of-10 counterparts by about 0.80 percentage points in each of the three years through 2016, Bloomberg surveys show. Inflation meanwhile will stay below the ECB’s target of about 2 percent.

Policy makers cut the main refinancing rate to a record-low 0.15 percent last month, started charging banks to park cash with the ECB overnight and unveiled steps to boost lending. They avoided printing money through quantitative easing, a process previously used by the Fed and Bank of England. The ECB’s next policy decision is due on July 3.

Central banks also rank among the biggest sources of risks due to the unprecedented nature of policies that have been pursued since the outbreak of the financial crisis and will have to be reversed as the global economic recovery strengthens, Milligan and Dunbar said at the meeting on June 24.

Policy Experiment

“The experiment and that unwind of that experiment are two ventures that have no instruction books,” said Dunbar. “There are still swathes of liquidity ebbing and flowing in the global financial system, the result of which is hikes in the prices of some assets. There are plenty of clever people thinking of how that policy will work.”

At the current pace, the Fed may complete this year a bond-buying program that has helped quadruple its balance sheet since 2008 to $4.37 trillion. Policy makers reduced it by $10 billion for a fifth straight meeting in June, to $35 billion.

Fed Chair Janet Yellen said at a press conference after the meeting that the central bank expected interest rates to stay low for a “considerable time” and declined to offer a more specific timetable for the first rate increase since 2006. The concern is the sheer level of debt, said Milligan.

“It’s completely unprecedented what central banks and governments generally have been doing,” Milligan said. “If and when interest rates ever start to rise or return to normal, the pressures would appear very quickly indeed.”

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