The Weekly Update

Last week we launched our Next Generation Global Bond Fund with USD 52m invested on day one. Like all our funds, the new fund looks for value in credit markets and draws on our insights gleaned from our NFA projections over the next few years. Demographics plays an important part with many of the world’s most indebted countries also suffering from shrinking populations. This combination spells trouble and is likely to result in downgrades for many of these countries and in some cases lead to outright default. Although immigration is a hot topic in Europe, very little attention is paid to the consequences of emigration; the problems of indebted countries with shrinking populations as a result of ageing populations is made much worse if some of their workers move abroad and do not return.

The initial Eurostat 2015 population estimates makes for an interesting, albeit somewhat depressing, reality check. According to Eurostat, as of January 2016 the population of the EU (all 28 member states including the UK) was estimated to have risen to 510.1m from 508.3m a year earlier. However, the key takeaway was that for the first time ever there was a ‘negative natural change’ of the population as deaths of 5.2m exceeded births at 5.1m: net migration was the driver of population growth.

More worryingly, Eurostat’s longer term projections in the Europop2013 scenario look for only a 2.4 percent population increase between 2014 and 2080 and a concerning increase in the dependency ratio (ratio of the elderly people at an economically inactive age of 65 or over versus the number of working age people i.e. 15-64 years old). The EU-28 old age dependency ratio is projected to increase from 28.1% in 2014 to 51% by 2080; in other words the working age to elderly person ratio will fall from 4:1 to 2:1, a sizeable drop.

Within Europe there are also signs of austerity driven ‘hollowing out’ although Ireland seems to be faring better than Southern Europe. It has the highest proportion of young people under 14 years at 22.1% of the population and the healthiest natural change of the population where births outnumber deaths. That said, Ireland’s crude birth rate has also been declining. In the Southern European countries of Greece, Portugal, Spain and Italy the trends are much less favourable: there is a negative natural change in the population. The Italian population only grew due to positive net migration in 2014 although the initial overall population estimates show the Italian population also declined in 2015. In 2014 Greece and Portugal experienced a ‘double whammy’ effect as negative net migration compounded the negative natural change. In 2014 Spain had net negative migration but positive natural change although the latter shifted into negative territory in 2015. Net negative migration is particularly damaging as it tends to be the young employable workers, particularly in countries afflicted with high level of austerity and unemployment, that move overseas in search of better employment opportunities.

Inevitably, these ‘greying’ and ‘hollowing out’ trends have negative implications for growth and productivity and create greater budgetary burdens on social systems. The IMF estimates going forward ageing could shave about 0.2 percent off total factor productivity (TFP) growth every year until 2035 in the euro area; this is significant as projected average annual TFP growth is estimated at only 0.8 percent per annum. They expect Greece, Spain, Portugal, Italy, Slovenia, Slovakia and Ireland to be the worst affected which, in conjunction with high debt levels, will create a significant impediment to growth.

Mario Draghi acknowledges the issue of “the euro area’s unfavourable demographics” stating “Public policy can certainly help temper these effects through its role in receiving and integrating migrants. But since policy cannot do much to alter long run demographic trends, the implication is that raising long-term growth will require a complement – namely, raising productivity.” But raising productivity is a complex issue that has probably been made more challenging with Brexit; in the sense that EU policy seeks to enhance the single market, promote scalability, create efficient labour and product markets, supported by effective financial and legal systems.

Unquestionably, Europe faces considerable demographic challenges but it is not an isolated case. According to the United Nations, the entire populations (not just those of working age) of 48 countries or areas in the world are expected to decrease between 2015 and 2050. With demographic trends already set in stone, it is hard to see anything but weak growth going forward, and that means interest rates and inflation are likely to remain low for several decades.

Meanwhile, as new Prime Minister Theresa May readied her cabinet to prepare for “Brexit means Brexit” we heard from the central bank, which kept rates on hold at 50bps. This announcement caught some market makers off-guard as consensus was for a 25bp cut. The pound surged to as high as 1.3475, before sliding back below 1.32 by the end of the week. The BoE clearly indicated that it will take action at the next meeting in August, no doubt armed with more post-referendum data releases to support the decision. Could we see the BoE following in the ECB’s footsteps by adding corporate bond purchases to its books?

Elsewhere, for the first time ever, a 10-year benchmark Bund has been issued with a negative yield! In fact even more surprising is the first ever non-financial company, Deutsche Bahn, issuing the first ever negatively yielding euro bond earlier this week. The Aa1/AA rated EUR 350m 5-year deal (initially marketed at EUR 250m) came to the market with a 0% coupon and -0.006% yield; the issue was surprisingly well absorbed. If yields continue to fall investors holding such paper will benefit from the capital gains, which will offset the interest rate cost; the pain will come when yields stop falling or indeed rise.

At Stratton Street, we do not hold any negatively yielding paper in our portfolios; we prefer to identify issues which have adequate spread cushion. The Deutsche Bahn issue is currently trading at under 50bps over Bunds, similarly rated 5 year bonds trade at just over 70bps according to our proprietary Relative Value Model, thus suggesting that the bond is “expensive”.

We would rather consider new issues from the likes of Taqa, an Abu Dhabi sovereign wealth holding company. The 4.375% 2026 bond, rated A3, was issued at ~290bps over UST. Since its launch around a month ago, the bond has performed extremely well, gaining almost 9 points, a tightening of over 100bps and currently trading at a yield of 3.4%. The bond continues to offer around 50bps spread cushion, but we will look to rotate out of this holding into a more attractive position as it approaches fair value.

With demographic trends likely to keep both growth and inflation low for several decades, long-dated investment grade bonds with yields in excess of 4% look extremely compelling and we are hopeful that the Next Generation Global Bond Fund will prove as popular our other funds.