Asset management: Re-rating spells ‘five years of flat bond returns’
Short-term rates must rise; Equities to reverse 20-year underperformance
The euphoric market reaction to the Federal Reserve’s decision at its September 18 meeting not to taper asset purchases was beginning to wane as Euromoney went to press on its October issue. Although the unexpected decision provided a welcome boost to many bond funds, everyone in the industry knows that rates have only one way to go.
One person who understands this more than most is Mike Niedermeyer, chief executive of San Francisco-based Wells Fargo Asset Management. Having been with Wells Fargo since 1987, he has seen short-term interest rates run all the way down from 11% to 1.6% during his time in the asset management business. Pimco’s Bill Gross has been busy tweeting that the market will be "front-end friendly for a long time", but Niedermeyer is well aware that this situation will have to come to an end. Euromoney meets Niedermeyer over breakfast in London in early September, before the Fed announced its decision to maintain its current level of quantitative easing. Although he pointed out that the conditions for interest rate rises were not yet in place, he said this would happen. "Short-term interest rates have to go up. We are not there yet, but this can emerge quicker than you think," he warned. "Markets can be caught unawares by this."
Niedermeyer predicts that short-term interest rates will rise to 3% over the next two to three years, with the 10-year and 30-year rate likely to reach the 6% range. "I worry that the investment markets are underestimating this," he says. "People look at the most recent experience and overweight that."
This rising-rate environment spells trouble for fixed income. "In the longer term what we have seen since June will be a minor blip," he says. "The market will re-rate. We may now have a decade-long secular shift with rates trending upwards. Equities have relatively underperformed and fixed income has outperformed its historical means. In fixed income we could have a five-year quadrant of returns where income offsets price loss. Investors could end up with returns that are flat while equities could significantly outperform. I think people will be surprised by the relative performance of equities over fixed income. Past decisions have forced a correlation between fixed income and equities but we could now have a return to negative correlation between fixed income and equities. There will be a reversion to the mean, with equities picking up their underperformance of the last 20 years."
|Mike Niedermeyer, chief executive of San Francisco-based Wells Fargo Asset Management|
As far as Niedermeyer is concerned, therefore, there is no question that the much-discussed great rotation into equities will become a reality, and he has a stark warning for asset managers that are not prepared for it. "We could have a shift in market dynamics that results in a rising tide for equity-oriented teams. We have had very good players in fixed income that have ridden that wave. Now firms that get it right on equity will do well. Firms that are traditionally strictly fixed income will find it harder and firms that don’t provide alpha or low-cost beta will struggle. If you don’t provide alpha, you had better have very low costs." This means that successful firms will need to provide strong equity and global multi-asset class solutions. Wells Fargo Asset Management had more than $450 billion in assets under management as of September 30 2012, which it manages via a multi-boutique model. Niedermeyer argues that simply broadening the mandate of bond funds will not cut it.
"I am sceptical around the trend of ‘go anywhere’ funds," he says. "The notion that they will avoid rising interest rates by investing in multiple asset classes is wrong – you are just broadening your risk boundaries. You are betting on sectors and durations, but most clients want to make that bet themselves. Multi-asset-class investing has been the holy grail, but it faces headwinds. There will be a move away from core bond weightings to equities, lower duration, customized fixed-income strategies and liability-driven investment."
He foresees implications for the yield curve from this transition. "Lower duration might keep the yield curve steeper. There will be more interest rate risk in the mid and longer part of the yield curve. When rates go up we will have a flatter yield curve, but some of these trends could mute that. We could have parallel yield curves and a re-rating of the yield curve in general."
Wells Fargo Asset Management is one of the larger US asset managers, but it has relatively limited exposure outside the US. Ranked 31st in the industry, it was the fastest-growing asset manager between 2006 and 2011. Niedermeyer’s goal is for the firm to break into the top 20, something that will be achieved partly through organic non-US growth concentrated on continental Europe, the Middle East and Asia. As he finishes his smoked-salmon and cream-cheese bagel it is clear, however, that the US markets are very much on his mind.
"Tapering could be the secondary story," he points out. "There has been a lot of talk about it, but it could be an outcome not a causation agent. If you believe that the world is getting better, how can you have short-term interest rates negative on a real basis?"