Knowledge. Shared Blog

August 2020

Japanification: Europe First and Now the U.S.

  • John Pattullo John Pattullo
    Co-Head of Strategic Fixed Income | Portfolio Manager

John Pattullo, Co-Head of Strategic Fixed Income, explains how the Federal Reserve’s suppression of volatility during the COVID-19 crisis has led to an almost idyllic environment to invest in corporate bonds.

Key Takeaways

  • Just as we saw in Europe, Japanification – which refers to Japan’s experience of persistently low growth, low inflation and low interest rates – has now spread to the U.S. and at a remarkably fast pace.
  • As was the case in Japan, the U.S. central bank’s suppression of volatility, together with its backstopping of investment-grade (and to a lesser extent high-yield) bonds, has created an almost idyllic environment to invest in corporate bonds.
  • With the collapse of the sovereign yield curve in the U.S., there have been large inflows into U.S. corporate-bond markets in recent months, with overseas buyers as the major participants. Interestingly, given the unending search for yield and quality, well-known investment-grade names are now almost the new sovereign bonds or the new benchmark rates.
View Transcript

John Pattullo: Hello, it is Friday, the 14th of August, I thought I would give you a brief update on thinking and our team’s thinking.

Now HSBC coined the phrase, “The decade of denial,” which really is the lower for longer, lower inflation, lower growth and lower bond yields, which many people denied, especially in America, less so in Europe. We have been on that view really from 2013 when we started speaking about Richard Koo’s “Secular Stagnation” thesis.

Now the COVID crisis we didn’t anticipate, nor the oil crisis, but of course we are not surprised by the direction of travel of bond yields. We are a little surprised by the pace of travel.

Now the Japanification of Europe was a big theme and that has played out well for us and for our investors. We think that is really spreading and has spread to the American corporate bond markets. If you look at Japan, what the central banks have really done is completely suppress volatility. That is almost ideal, an idyllic environment for investment-grade corporate bond investing, compounded by the Fed [Federal Reserve] backstopping investment grade and to a lesser extent, some high-yield default risk with the purchase of corporate bonds in investment grade and high yield. You combine that with massive, almost a desperate search for yield.

You know, I have been doing this 20 years now, and all I have really heard is people [saying], “give me reliable sensible yield.” So, what we have seen is a lot of supply, and [Portfolio Manager] Nick [Ware] has recently written an article saying that bond glut is really moving to a bond drought, and that is a topical piece. The suppressing of volatility, the underwriting of systemic risk and investment grade is really a systemic asset class driven by vexed volatility and to a lesser extent, default probabilities.

In addition, you have had big inflows, as I spoke about, and very limited inventories in the Street. And overseas buyers have been a big participant in the American corporate bond markets because as interest rates have come down, the hedging back-to-liquid currency costs have come down. So, actually, we think corporate bonds in America are actually pretty cheap on a relative international scale, and that desperation for yield we think will only continue. Look to Japan, the evidence is in Japan – the suppression of volatility, lower move and [Cboe] VIX indexes suggest volatility has been suppressed by the central banks. That is a great environment for corporate bond investing.

In some ways, the quality, sensible income names are really almost the new sovereign bonds. Almost the new risk-free rate, you know well-known names, are almost the new sovereigns, the new benchmark reference rate because the sovereign curve has completely collapsed. This is exactly what we saw in Europe and it is exactly what is playing out in America. And if anything, it is playing out remarkably fast. But still, we think some people remain underweight bonds and the flows are really massive and almost terrifying, even though I have been doing this a long time.

Finally, I would like to highlight some of the research the team has recently done. I wrote a piece, “So, What About Inflation.” And I think people shouldn’t confuse inevitable, cyclical uptick in bottlenecks and price volatility and commodities and lumber and gold and copper with a cyclical breakout with a secular or structural shift. And that will probably be the debate next year.

I mentioned Nick’s article, “From Bond Glut to Bond Drought,” and then Jenna [Barnard] has also written, Jenna and Nick have written a piece recently about breaking the link between GDP declines and default rates. Default rates in America will be higher because the constituents of the index are generally worse and less government bailouts. Where in Europe, we think default rates might actually be quite low. The zombification of names, but massive government support. Germany, for example, has put almost €3 billion via varied agencies into [tour operator] Tui; they put €9 billion into Lufthansa, and there is a lot of socialization of risk in Europe unlike in America. And that is an interesting divergence.

So, to summarize, we remain pretty bullish. Corporate bond spreads, they have come a long way, but that suppression of volatility, like what happened to Japan, is the main point. Thank you very much for listening. If you have got any thoughts or questions, please contact your local salesperson. Thank you.

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