Macro Views on Global Fixed Income

Macro Views on Global Fixed Income

 

Speaker names and titles:

Anna Martin

Relationship Manager

Pilar Gomez-Bravo
Co-CIO Fixed Income

Anna Martin:

Investors have begun to hope that the central banks are nearing the end of the tightening cycle. However, there’s still plenty of uncertainty in the markets. A question that is on a lot of our investors’ minds is around inflation. Have we seen the peak and will the central banks be able to orchestrate a soft landing?

Pilar Gomez-Bravo:

That is kind of the most topical question obviously these days. And I think what’s interesting, maybe less people perceive is actually the macro backdrop for the economies is very different. It's just that yields have been moving in a very correlated fashion, assuming all central banks carry on with the same policies of tightening ahead. So, it really depends in terms of the inflation and the growth outlooks for each of the major economies. So, for example, in the US, whilst inflation has peaked, it is still pretty sticky and especially if you think about services inflation and housing. So, that's kind of what Powell is really mostly focusing on. In Europe on the other hand, we haven't really seen core inflation peak. In fact, the most recent data pointed to continuing up trend in core inflation, which is worrisome and which is why the ECB which started late, its monetary tightening continues to push ahead in a very hawkish manner.

If you think about the UK, it's probably the most dovish central bank out there, frankly, on the sort of developed market side. And they have quite a difficult inflation paradigm where you have different sources contributing to inflation, whether it's food, energy or wages due to the tight labor market. So, whilst they are quite dovish, inflation is still a pretty stubborn problem.

And then of course, we have countries like Japan which is seeing their inflation increase significantly. But with the new governor they still seem to be committed to a very loose policy, even though we think that that's likely to slowly change in the future. And that leaves us obviously Australia and New Zealand and other markets, which I think here, leaving aside, obviously the issues around Cyclone Gabrielle in New Zealand, which is still quite recent and difficult to predict, the central bank here and the RBA, which is meeting and expected to high rates again, still has a very rate sensitive economy and so it's difficult to see that they will be able to tighten inflation much more and that inflation has probably already peaked as well.

Anna Martin:

What do you think we can expect from the market in the coming months, in the next 18 to 12 months and what do you think is already priced in?

Pilar Gomez-Bravo:

Well, I mean I think our base case is that we need to expect recession. I mean I think most people moved from basically no landing, i.e., growth stays on as much as it is, especially in the US to soft landing to mild recession, but it's only going to be a technical recession. And so really people don't want to sort of really consider the implications of potential recession in the next 12 to 18 months.

But the reason why we feel that that is our base case is because given the stickiness of inflation that we were just mentioning before, it's difficult to see the central banks not over tightening. They are really, in most cases, very data dependent and therefore reacting to data, which means they're behind the curve.

And in that context, there's likelihood that an accident happens, they tighten too much, the lags into the real economy take a little bit longer than usual and then suddenly you have a much more difficult recessionary outcome. And so, that is kind of what we think you might see in the next 12 to 18 months. And frankly that's not really priced in to the markets, at least the risky assets markets. If you look at how much equities have rallied and how much the credit markets have rallied at the beginning of the year, the base case is not priced in as a recession. The base case that's priced in is really kind of landing into this soft mild recession outcome at most.

Anna Martin:

So, there is a lot of talk about the Fed being able to cut rates towards the end of this year or the beginning of 2024. What's your view on this?

Pilar Gomez-Bravo:

So, a lot depends on the path. The more they hike now, and the more the curve continues to invert signaling and pending recession, the more likely it is that they have to cut earlier. Because obviously, you trigger the recession and therefore you suddenly have to unwind some of the monetary tightening that's taken place.

So, it really depends. The more they do now, the more likely it is that they have to cut and you might see those cuts being priced into the market again; the less that they do now, the more likely it is that we're going to have to stay at very high levels of rates for a more prolonged period of time causing even more prolonged pain in companies, households that are need to refinance that debt.

Anna Martin:

Spreads have widened significantly and yields are more attractive today. Are we at the point where investors should reconsider the allocation to fixed income and what role can it play in clients' portfolios?

Pilar Gomez-Bravo:

So, I think it's a very exciting time for fixed income. I mean we really haven't seen these levels of yields for at least 10 years. Obviously we haven't seen this level of inflation either for about 40 years. So, it is a very difficult market to navigate, the fixed income asset class. But it is an exciting asset class because you're now getting in most very high quality defensive portfolios, at least 5% yield in US dollar terms. And depending on how global you want to be, which we always advocate to broaden your investment horizon and your universe, that allows you to play around with some of the hedging yields that you can get.

So, I think that this, for the first time in many, many years since the GFC, you have fixed income yields with that sort of promissory coupon that is higher than earnings yields in the S&P 500 for example. And so, if you think about the drawdown risk on top of that for equities going into this slowdown, then I think it's pretty interesting to have that allocation again in fixed income that gives you income finally and it gives you capital protection again and therefore allows you to diversify your exposures and your risk with a level of income that also provides you the yield that you need to allow for people to retire and people to invest.

Anna Martin:

Being picky seems to be the way forward, yes. We talked about recession risks and cost of capital is increasing. We seeing falling profit margins. In what shape are corporates to navigate this type of environment? And do you see any sectors more at risk than others in the near term?

Pilar Gomez-Bravo:

One of the most interesting elements of investing in credit is that you have the bottoms-up security selection lever that compounds and it has the best information ratios. But at the same time, you have sort of a top-down lever that you can pull to generate alpha. And the most exciting times to be an active manager in global credit is when you have dispersion in sectors and you have volatility. And so, that's what we anticipate and we are starting to see dispersion across the credit markets. And when you're constructing risk, which is kind of what we do as portfolio managers, you can sort of play with beta and, for example, in Europe because everything widened, you can sort of basically create more beta from that part of the market. And at the same time, the US credit markets offer you a lot of dispersion between sectors.

So that allows you to create a package of risk that really fits that sort of upside return within the bottoms-up ideas from the analyst. I would sort of say as well with regards to the opportunities that we still favor banks both in Europe and in the US. And the reason for that is twofold. One is because there were large suppliers of bonds in the market and therefore their spread's wide and therefore are pretty cheap relative to the non-financial corporate sector. So, you're picking up spread.

They tend to be higher quality if you're going up in cap structure. So, we sort of favor having more exposure to senior debt rather than very deep subordinated debt at this point because of the cycle concerns that we have, and therefore your ratings tend to be really higher. So, the banks also are one of the few sectors that actually benefit from rates increasing. So, when you think about building risk in credit, you want to, at this point in time given the inflation concerns and rate dynamics, you want to be avoiding rate sensitive sectors, you want to go into sectors that benefit from rate increases. So, banks, for all those reasons, is one of the sectors that we prefer in our portfolios.

Anna Martin:

How do you and the team think about energy supply dynamics and the implications for global credit markets?

Pilar Gomez-Bravo:

So, we have two pulling factors in energy markets and particularly obviously oil. The first one is a current paradigm of you have a war in Russia, you have caps and sanctions and you have China reopening at the same time. So, that normally would lead to higher oil prices basically, at least in the short term. At the same time in the US, they're building or rebuilding their storage, so their reserves, and that again sort of draws demand for oil higher. And on top of that, you haven't had any new exploration because of green concerns around fossil fuels.

So, you could have a crunch in the very near term that leads to oil higher. However, in the longer term, usually it's obviously a market that is driven mostly by global demand and supply considerations. So, if your base case, or if you're expecting a significant slowdown in global growth at some point and potential recession, then longer term you'd have to think that energy pricing comes down. One of the key things that we're looking forward to is really kind of continuing to engage with the energy companies that we talk to understand their CapEx plans as they think about this transition in energy policy going forward. And that again, will sort of create maybe different options to energy that companies can use beyond just with traditional oil markets.

Anna Martin:

Absolutely. Well, thank you very much for your insights Pilar. That's been absolutely fascinating. Thank you for tuning in and hope to see you soon.

 

 

 

This material is intended for investment professional use only and not intended for retail investors

The views expressed are those of the speaker and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation to purchase any security, or as an offer of securities or investment advice. No forecast can be guaranteed. Past performance is no guarantee of future results.

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