Is it possible to find opportunities in a bond market that has remained bullish for 35 years? According to John Stopford, Head of Multi-Asset Income at Investec Asset Management, there are still possibilities to find value in fixed income markets, although they are increasingly difficult to locate.
During the Investec Global Insights 2017 celebration in Washington, the manager reminded attendees of the origin of the current context. It all began when, at the end of the 70s, after a period of high inflation, Paul Volker, Chairman of the Federal Reserve, decided to put an end to the growth of the money supply. Since then, and except for short periods in 1994 and 2008, fixed income has not stopped rising in price. If we add to this a much lower growth than in previous times, with secular stagnation, as argued by Larry Summers, former Vice-President of Development Economics and Chief Economist of the World Bank, the result is an environment in which rates of developed governments are excessively low and will most likely not increase significantly. The real growth of the US GDP has decreased, and inflation has also diminished, although the Fed can now manage a restrictive monetary policy, the change will be slow, incremental and will take a while to increase.
“If clients expect to see US Treasury bonds back to 5% returns, they are probably wrong. Since the financial crisis, central banks have injected billions of dollars into financial markets, but the costs of expansive monetary policies are now beginning to outweigh their benefits. Central banks have begun to eliminate their excess supply, which will surely trigger a rise in rates. The Fed estimate is a rise of 60 basis points, it’s not much, but we must get used to these figures. We should not expect increases of 200 basis points, potentially being able to reach 50 – 100 basis points at some point during this new cycle,” Stopford pointed out.
Another issue that should worry investors is the US package of fiscal easing measures. An increase in the country’s budget deficit could raise interest rates, and given the point at which the cycle is located, it may also push up inflation expectations. “If the US deficit increases materially, real bond yield rates could be pushed upwards. The question is whether Donald Trump will be able to get approval for a 3.5 trillion dollar budget, because he needs each of the Republican senators to vote in favor. Both the application of an expansive monetary policy and the withdrawal of central banks are actually risks. The Fed has already shown all its artillery. In one of her latest presentations, Janet Yellen basically mentioned that inflation is a mystery; an alarming statement coming from the person whose aim is to control inflation in the world’s largest economy.”
According to the Investec manager, the recent weakness in inflation is partially transitory and he expects it to reverse sometime next year. Inflation can also be driven by lower unemployment, a weaker dollar, and firmer commodity prices. And, if the fiscal expenditure package is finally approved, it would have an inflationary effect at this stage in the cycle.
Returning to the economic normalization program, the Investec manager said that the Fed wants to continue raising rates, he believes that now is the appropriate time to abandon the quantitative easing policy, reversing bond purchases in its balance sheet. “Rates will not rise to 5% levels; they will probably stay at 2.5% levels. Furthermore, the market does not believe the Fed, thinking it is the boy who cried wolf, even though the Fed has already narrowed the market down to a greater extent than was expected during the past year. But, perhaps now is the time when the market should probably converge with the median of the Open Market Committee’s projections.”
As regards the positioning of the portfolio, the Investec manager recommends being careful with a potential sovereign crisis in the short term; mentioning that the opportunities could be in countries such as Australia, the Czech Republic, and Canada.
Corporate debt
On the corporate credit side, there are two reasons why credit spreads are at levels as low as the current ones. The first issue is the risk of recession, if you compare the spreads of high-yield debt in the United States with the probability of entering a recession, you can see that there is a strong correlation in their behavior, especially when there is a sudden movement. A recession causes companies’ balance sheets to begin to suffer, and it’s then when they cannot pay the debt they borrowed. According to Stopford, the current risk of entering recession is low, at least for the next 6 to 12 months.
The second metric that must be taken into account is the absence of volatility. The VIX is the measure of the cost of insuring a portfolio, the implied volatility in equities, which is to a certain extent the equivalent of buying insurance. But at the moment investors are more focused on obtaining returns, and are willing to trade security for returns. “If the credit spread indicates how much uncertainty there is around companies in the future, the VIX is exactly the same issue for equities. You can see that they both move together, so it should not be surprising that credit spreads are so compressed. Can they remain at that point? Yes, for a while, because thereis still not much volatility in the short term and monetary policy is still not affecting enough.”
Although Stopford recommends lower exposure to corporate debt due to its limited risk premium, the fact that the environment remains favorable for growth, suggests that opportunities could be found in the diligent selection of credit.
Emerging market debt
Investors continue to worry about everything that did not work in emerging markets in 2012 and during the period 2015 -2016. But the main opportunities could probably be found within this asset class, real bond yields are above the US rate, which is negative, as in most developed markets. Some emerging markets continue to cut rates and some have begun to raise them gradually. In addition, there are numerous idiosyncratic risks, so it pays to be selective. “You should not invest all your money in emerging markets, you should have a diversified portfolio, but this asset class shows good performance between fundamentals and valuations.”
In emerging markets the debts of Israel, Hungary, Chile, Peru, and Mexico are at reasonably attractive levels.
Foreign currency positions
Currencies usually behave much like a roller coaster. The good news is that they don’t usually move together, so it’s usually a field of opportunities. In this regard, Investec recommends taking advantage of the relative optimism seen in Europe as compared to the United States, cautiously selling the euro against the dollar. At the same time it sees an opportunity to position itself long in the currencies of certain emerging markets, such as the Czech koruna, the Indian rupee, the Mexican peso, the Hungarian forint, the Indonesian rupee, the Chilean peso, the Peruvian nuevo sol, the Egyptian pound, the Thai baht, and the Turkish lira.