Liontrust GF Strategic Bond Fund

The Liontrust GF Strategic Bond Fund returned -2.1%*in US dollar terms in October. The average return from the EAA Fund Global Flexible Bond (Morningstar) sector, the Fund’s reference sector, was -1.1%.

Market backdrop

US labour market data at the start of October set the scene for a weak month for sovereign bonds. Nonfarm payrolls were reported to have grown by 254k in September; the first revision to this reduced it down to 223k but that is still a strong number. The downward trend in the six-month moving average of nonfarm payrolls remained intact but it was undoubtedly a strong data release compared to forecasts. Outside of one month’s data, the bigger picture is that the US labour market has moved much closer to being in balance. Most of this has so far been achieved through a combination of hiring falling and increased supply (through recovering participation rates and a surge last year in net immigration). It is not plain sailing as smaller businesses have felt the impact of higher interest rates much more than their larger cousins – with margins under pressure, this impacts the demand for labour.

The Federal Reserve (Fed) has sometimes described the labour market as “non-linear,” effectively meaning when unemployment goes up it can suddenly accelerate. With consumption still robust, I continue to expect unemployment to peak in the 5-6% region in this cycle. 

On this side of the Atlantic, in a unanimous decision the European Central Bank (ECB) cut interest rates by 25 basis points (bps) to 3.25%, as anticipated by all economists and market pricing. The rational for the cut was based on the ECB’s “…updated assessment of the inflation outlook, the dynamics of underlying inflation and the strength of monetary policy transmission.” As many may recall, at the September ECB meeting press conference President Lagarde stated that there was a “…relatively short period of time” between then and the October meeting which strongly hinted toward a pause at this October meeting; so, what changed? Firstly, and most importantly, inflation data surprised to the downside, including further progress being made on sticky services inflation. Secondly, as well as hard economic data, there has also been a downturn in soft data such as the fall in the PMI surveys.  Economists and the markets had adjusted to the data, along with strong hints from ECB governors, such that the interest rate cut this week was 100% forecast.

The recent weaker data has accelerated the pace at which the ECB will seek to return to a neutral monetary policy stance. With monetary conditions still characterised as “restrictive,” updated economic forecasts will empower a faster pace of rate cuts. I think the market will turn to focus on estimating where neutral is and my best estimate for the Eurozone is that it is in the high-1% to 2% area. For the market to start to look for policy to move to loose territory it would take a further deterioration in the economic data and/or an exogenous shock.

Finally, in a continued reminder of the amount of supply the bond market is having to absorb, we had the first Labour budget for 14 years in the UK. I am not going to go into the minutiae of any of the changes, but rather focusing on the bigger picture. The cumulative tax rises by 2027/28 are expected to reach an annual rate around £40 billion; over 60% of this is attributable to the change in employers’ national insurance contributions (NIC). Spending is set to increase by almost £70 billion a year over the next five years, albeit two thirds of this is current spending and the other third capital spending. The Office for Budget Responsibility (OBR) estimates that borrowing will increase by £140 billion over the next five years relative to the March budget projections; on this I must note that an increase was inevitable as March’s spending projections had zero credibility. I also note that Chancellor Reeves has left herself only a small buffer of £9.9 billion, meaning there is very little room for error in the plans. 

Overall, it was an expansionary budget with spending going up by more than taxes. The tax burden is set to drift upwards to 38.2% of GDP compared to the prior trajectory of around 37.1%. The OBR estimates the size of the state by the end of the decade to be about 44% of GDP. While there will be a boost to growth in the next few years through the front-loading of extra current government spending, the longer-term impact is more mixed. Hopefully, the capital investment will lead to greater productivity gains and higher economic capacity; this is something we’re unable to judge for a few years. Also, there will be some classic economic “crowding out” of the private sector. On the higher employer NICs, if these are passed through to customers via price increases then they are clearly inflationary. However, our gut feel is that more of the cost will be absorbed and medium-to-larger companies (the increase is not binding for very small companies) will end up shedding staff either through redundancies or natural attrition. 

The rise in gilt yields due to the budget was a rational market reaction in isolation; economic growth will be higher than previously forecast and there is the aforementioned huge amount of extra supply for the bond market to absorb. However, in the build up to the budget, the gilt market had already hugely underperformed other sovereign bond market and I would argue that a large portion of the UK term premium (or, to cut through jargon, extra risk priced into gilts) can now start to fall. We are global developed market fixed income managers, so the UK is only a small part of our investment universe; furthermore, we psychologically tend to avoid gilts to avoid accusations of home market bias. Presently, we believe gilts are very cheap both in outright terms and relative to other sovereign bond markets.

Fund positioning and activity

Rates

The Fund’s duration was increased during the month to finish October at 7.25 years of exposure. When the differential between gilts and bunds was close to 200bps we switched some German duration into the UK. The spread between New Zealand sovereign bonds and US Treasuries narrowed significantly during October; we took profits on half of the Fund’s position. This leaves the geographic split of duration as 3.3 years in the US,     -0.5 years in Canada, 0.5 years in New Zealand, 1.8 years in the Eurozone, and 2.1 years in the UK. As a reminder, we continue to think that yield curves will steepen further. The Fund’s net duration exposure in the 15+ year maturity bucket is zero; we prefer short-dated and medium-dated bonds. 

Allocation and selection

Credit spreads remain expensive by historic standards; the Fund is underweight with 45% in investment grade and 15% in high yield (21% in bonds minus a 6% overlay), compared to neutral levels of 50% and 20% respectively. Credit fundamentals remain robust. We are just awaiting a better valuation opportunity to increase exposure.

At the stock level, profits were taken in a Bank of New York Mellon subordinated bond which had become fully valued. A new issue afforded us the opportunity to buy back into Heimstaden Bostad’s bonds as our confidence in the company remaining investment grade has greatly increased and the underlying fundamentals continue to improve.

Discrete years' performance (%) to previous quarter-end**:

**Source Financial Express, as at 31.10.24, total return, B5 share class. Discrete data is not available for ten full 12-month periods due to the launch date of the portfolio (13.04.18).*Source: Financial Express, as at 30.09.24, B5 share class.