Replay: Keep Calm and Carry on Diversifying

Benoit Anne: Hello, everyone, and welcome to our Global Fixed Income in Focus webcast. I'm Benoit Anne, the Head of Market Insights at MFS, and I'm joined by Pilar Gomez-Bravo, our co-CIO of Fixed Income. So, Pilar, thank you so much for being here.

This is our Global Fixed Income webcast, so we're going to talk about multiple countries around the world. Let's start perhaps with Japan, which has pretty much been on everybody's radar right now. So could you please start by discussing your view on the BOJ and also the famous carry trade that scares many of us?

Pilar Gomez-Bravo: Yes, definitely. I think that Japan has become the epicenter of global bond market attention. And the reason has been an evolving one. The first one is that we are clearly in regime change in Japan after many, many decades of disinflationary trends and lack of growth. We have seen, really since 2022 actually, a pickup in core CPI as defined by the Bank of Japan that has been above their targets. And also, we have seen growth, again, and wage pressures together with capital inflows down to the stock market driven by AI. So clearly that has unnerved a lot of the investors, mainly because of the yen carry trade that you mentioned. We do think that the direction of travel is clear for higher rates. I think we're all very frustrated, in fact, that the real yields are still negative in Japan because of the very slow pace of the Bank of Japan monetary policy evolution.

So while the direction of travel is clear, the speed of travel is not. And I think this is where the markets are trying to ascertain what impact a Bank of Japan policy will have on the yen. So we do think that we will get an increase now in this week at the end of the week to 1.25%. Ultimately, we think the terminal rate goes into 1.75%. That's in between of this neutral range that the Bank of Japan has established, so there could still be higher levels. But actually, what matters then is really if this trend has to accelerate. And the reason why there's a little bit more nervousness now is because with all other central banks having to potentially increase rate, that just leaves the Bank of Japan further behind with regards to their hiking cycle. So what does it mean for the yen, which is really at the main center of attention because of the impact of it being used as a funding currency to invest in other assets and other asset classes?

I think that right now, we expect a little bit better support for the yen, mostly because of the interventions that we have had recently, and also because there is that appreciation of Bank of Japan policy moving slowly to where it needs to be. I think a lot of it for the yen will depend on the structural capital flows that we see, whether or not the Japanese repatriation back into Japan, like we've talked with GPIF, maybe including higher domestic bonds. But I think the key market conclusion is actually to expect more volatility in the yen rather than a one-off directional view or a one-way trade. So what's going to matter? If you see the Bank of Japan being faster in its hiking cycle, if you see credible policy independence, if you see official intervention or interest rate differentials that narrow, then I think that supports the yen, and the opposite is true if that doesn't happen.

Benoit Anne: So you've mentioned higher rates in Japan. It's the same story in many other places. So away from Japan, looks like the global duration backdrop has become a little more complicated. Can you tell us how you navigate that and when you see opportunities from a global duration standpoint?

Pilar Gomez-Bravo: The duration outlook has certainly become more challenging, needless to say. And I think we do continue to focus a lot more on relative value opportunities. When you do have a global landscape, then you can think about yield curves and you can think about country relative value. I think it's a much harder case to make for just outright directional duration. In essence, I think that the conclusion for us is that duration used selectively and globally makes sense in portfolios, in fixed income portfolios. And when you have, again, everywhere or anywhere to go to, we continue to think that we're not really overwhelmed by having duration in the US. We do think that a lot depends there on the credibility of the Fed and the uncertainty around Warsh. And we do expect that he should be hiking in September, although who knows whether he will or not.

And that leads us to continue to advocate for a flattener position in the US. Maybe moving from 2s30s, probably more to 5s30s is our preferred position there. We do think that we favor markets where there's a lot more hawkish pricing in. We were just talking about Europe before we started this chat. And I think that when you think about markets that are pricing in a lot more than its relative growth warrants, then I think that starts attracting interest. For example, in Europe, we would probably favor more steepeners, because I think a lot has been priced into the front end with regards to hiking expectations from the ECB. And frankly, the growth is relatively fragile in Europe. You don't have this AI boost there. We continue to like the UK duration. And again, there we favor the belly of the curve. We think that the UK had been restricted before this war started in Iran and therefore never really got down to the level of neutral rates that the ECB had. So we continue to like the yields at the front end relatively high and again, supported by the backdrop of growth in the UK, even though we are running into a budget discussion in October. So that's going to potentially increase volatility there.

But again, another area that we think is very interesting is actually emerging markets. We do have exposure to local emerging markets. They provide diversification, they provide attractive real yields. Some of these countries actually have not-so-bad inflationary backdrops, and, in fact, have room for easing of monetary policy. And if you think about some of the countries, for example, in Latin America, we think that they offer a nice balance of carry and roll down and yield that could be attractive for portfolios. So again, I think that the fiscal concerns, rising term premia, divergent central banks' paths all favor more relative value tactical positioning.

I think that in essence, the easy era of duration has passed for now. So we, again, think that actually being global adds value to duration positioning through diversification.

Benoit Anne: Very good. Yeah. You are always very good at identifying key themes, and one of them that has popped up on your radar is precisely scarcity. Can you explain to us how that theme of scarcity frames your analysis of the global market backdrop?

Pilar Gomez-Bravo: Yes. I think that as we look at all the markets, obviously in global fixed income multi-sector, you have multiple asset classes plus multiple countries. But I started thinking about what were the common themes that were impacting some of the moves that we're seeing, whether in spreads or yields. And scarcity was one that kept coming up in my mind, in three ways. The first one is the obvious one of scarcity of commodities. We talk a lot about energy, but not just energy. We're talking about fertilizers compounded by El Niño, compounded by the war in Ukraine, diesel; not just pricing, but access to the commodities becomes an important issue when you think about inflation across the world and which countries have access to commodities and which ones don't, including metals, as well, industrial metals. That's one area that continues to support potentially higher inflation expectations, at least for the time being, until and if we see a resolution of the war in Iran, even though it will still take quite some time to get access to the commodities, basically.

The other area of scarcity is scarcity within the AI infrastructure build-out, not just around the obvious things like power and energy obviously as well, and water, but also labor. You don't necessarily have the amount of labor to do all the developmental construction, as well, and scarcity of willingness by a lot of these states to accommodate datacenters. So that is going to create friction. That friction will continue to showcase an intermediate inflationary pressure that will continue from the initial early stages of the AI build-out because of the scarcity of the inputs that you need to deliver the big amount of compute that is presumably required for us to develop AI.

And the final one is a little bit more unnerving in a way and new, is scarcity of capital. For so many years, Benoit, we've been talking about the glut of savings, especially in Asia, that would sort of fund everything and anything. And for the first time we're actually seeing scarcity of capital because a lot of the usual providers of capital now have their own needs, whether it's Japan or the Middle East or Europe. And at the same time, you have just funding requirements through the CapEx of AI plus the funding of government bonds that are just requiring and demanding more from us as bond investors. And therefore, naturally, what you're seeing in the markets from this scarcity theme is that it's just pushing real yields higher. So you're not really quite yet seeing inflation breakevens shooting up, but what you're seeing is that investors demand higher yields because there's only so much capital to go around. And as long as the CapEx requirements are there, as long as fiscal deficits are there that need to be financed, then it's difficult to see a significant lowering of yields barring a major risk-off event.

Benoit Anne: Yeah. So clearly, scarcity is one source of risks, but there are many others. I think you already mentioned geopolitics, of course, but what would be your top three risks at this point?

Pilar Gomez-Bravo: Well, I think the AI infrastructure build-out is an ever-expanding theme, mostly because, again, just a lot especially is priced into the risky assets and also the demand for funding in the investment-grade markets and the fixed income markets. So that's one area that keeps cropping up together with, obviously, commodity prices as I mentioned.

The other area of risk that we don't seem to be talking much about anymore is private credit. We seem to have forgotten about it now that the oil price has dominated the themes, but that is still there, especially with these higher levels of yields. The risk is that at some point there is fragility in the markets that we're not seeing. I just noticed, I don't know if you've seen, that a major real estate developer went belly up in Australia, right? Again, a market that has also had a significant amount of growth in private credit, mostly attached to real estate.

So it's not just a phenomenon in the US. It is a phenomenon that we might start seeing. And if these yields remain high and the Fed has to hike, then that just makes financing much harder to refinance, actually, when they come to market in the next couple of years, and therefore potentially increasing higher defaults. Are we seeing that yet? Actually, we are. We're seeing it because there's increasing dispersion in things like triple-Cs or leveraged loans where the haves and have nots are clear, less so at the overall index levels because credit spreads are still tight. But once you start looking through the surface, then you start seeing some of these dislocations. Now, of course, for us, it's an opportunity because we're active investors, but in general it does show that that private credit market is still going to potentially find some fractures, especially if you need, for some of these large institutional clients of private credit, to start liquidating some of those exposures, and that could be a significant risk for the market.

Benoit Anne: Yeah. Of course, very important to discuss risks, but you also said two keywords here: dispersion and dislocation. I'm sure our clients want to hear about opportunities. So tell us how you see that set of opportunities right now and how you are positioned.

Pilar Gomez-Bravo: Yes. It's always exciting when you have dislocations, especially when you have a global universe that you can invest in, because you don't have to just stay within one narrow market, either asset class or country, to identify opportunities. I think that you don't need to be a hero. I think there's a lot of uncertainties right now. I think what is attractive is the overall levels of yields are still pretty compelling with regards to breakevens longer term. If you think about a fixed income asset class over a long period of time, then I think you start seeing these levels of yields where you can get portfolios relatively defensively structured of 6% or 6.5% yield over a long period of time, then that starts becoming still a compelling value addition, especially if you do believe that at some point there is a cycle that turns whilst maybe not expected right now, eventually they will start seeing that inverse correlation kick in, again, not quite there yet.

So what do we do in the meantime, whilst there is still a lot of growth and an early-cycle experience or feeling in the markets? I think defensive carry is still very interesting. And what do I mean by defensive carry? I think, as I mentioned in duration, you still can pick up carry and roll in certain parts of the market that can beef up and diversify an overall yield and carry experience without having to go into lower quality exposures. So that's one thing that we're doing, again, picking parts of the curves, as I mentioned, 5-year here, 30-year JGBs and New Zealand government bonds, 30 years pretty attractive, good carry, good roll down, good head shields if you're a US investor. And at the same time, in your credit exposures — because overall credit markets are still tight in terms of spreads — you can still have a composition that is diversified with a good amount of carry.

What do I mean? We like some investment grade as a core. Again, usually you don't have a huge amount of default risk in investment-grade exposures, but you don't need to go out really in the long end of the curve. The curves are still relatively flat. So we would advocate for spread durations that are shorter than they used to be because we don't feel we're necessarily getting compensated by going out the curve, especially when supply is large. In other parts, for example, emerging markets, corporates, or sovereigns, there are still opportunities in some of the crossover space. Again, focusing on the front end where you can sort of measure the cash flows to pay you back is always interesting. And the same thing goes for high yield. We tend to prefer a little bit more US high yield than European high yield, again, going back to the growth demands and dynamics that are more supportive for the US economy than they are in Europe.

So again, just giving you a little bit of that extra spread with that single-B to double-B type of quality whilst picking selective triple-Cs that our analysts like. If you think about that, if you think about some of the other markets that we can go into, then you start getting a very well-rounded portfolio that is diversified with good carry that you don't need to shoot the lights out until there's even a bigger dislocation in which the liquidity that we have in our portfolios will allow us to participate in dislocations when they do come. In conclusion, maintain liquidity, diversification, and defensive carry as an opportunity for investors until we have more clarity with regards to central banks, the geopolitics, and the AI story.

Benoit Anne: Okay. Well, excellent. So that concludes the main parts of the webcast, but of course, we've received many, many questions from our clients. So thank you for that. So I'm going to throw a few of those at you. And you already mentioned AI as part of the discussion on scarcity. The first question from clients that we want you to address is, what's the impact of the AI boom on fixed income?

Pilar Gomez-Bravo: That's an exciting question because, actually, it has two sides to it. The growth engine of AI is positive for credit fundamentals. And at the same time, it's a funding challenge. What do I mean by that? I mean that it has been a major engine of growth and probably presumably will continue to do so, not just from the CapEx and the infrastructure and not only from the hyperscalers, but also all the ecosystems that now exists in the development of the construction of the datacenters, the picks and shovels industries, but also because of the wealth effects that it's generating in the equity side, thinking that, again, usually households in the US are very exposed to equities, not the same in most other countries, so maybe 70% exposure, which is very high. And through that, you're supporting not just the consumer spending, but also you're supporting corporate revenues, corporate earnings, maintaining default rates low in the broader public credit markets.

So that should be supportive for credit fundamentals and therefore creating a level of spreads that are contained. On the other hand, as we have seen for the last year, it's just ever-increasing amount of supply that we're seeing to fund this AI CapEx is starting to trickle down into divergent and dislocations in terms of sector spreads. And this surge in debt issuance, as I mentioned with scarcity of capital, basically means that this datacenter build-out and semiconductors and power infrastructure hyperscaler compute has to be financed by the bond markets. And we're starting to see the bond markets that sometimes are more sensible than the equity market, saying, "maybe we're going too fast, maybe there's just too much." Keep in mind it's not only investment grade and on-balance sheet financing. There's a lot of off-balance sheet financing and therefore, these issuances that we're seeing that are actually very interesting potentially require a lot of research, which our teams do with regards not only to the fundamentals of the lender of last resort, let's say, but also the structure of the deals.

And we have teams of lawyers that work with us to anticipate potential challenges when we're involved in these deals. That supply that we expect in a significant amount of issuance is going to put a floor on spreads, which means that maybe the buy-the-dip scenario is not as obvious or as easy as it used to be, and that seeing never-ending compression of spreads is also maybe unrealistic while we still have to absorb so much supply at our markets. However, these higher supply also and higher yields is going to be at the short term inflationary, which is going to be negative, as we talked about, for yields. So that's also a general adverse impact.

Having said that, I think that the key message here is that all this provides significant opportunities for us, because, again, in the past, credit had just become a very margin-compressing, spread-tightening environment with no dislocations across sectors or issuers. And now we do see that. We see a significant amount of opportunities. But in essence, we rely on our research to provide us the opportunities. And I think that selective security selection and relative value is the name of the game when thinking about AI, which is now a big theme in most investors' portfolios that now not only have to contend with the concentration in equities, but also now think about what that AI impact is also on their fixed income exposures.

Benoit Anne: Yeah. Very good. Another client question is about the dollar. What's your view on the dollar outlook?

Pilar Gomez-Bravo: The dollar always elicits a lot of strong emotions when thinking about fixed-income investing in general. I think that there's a difference between a tactical approach to the US dollar and a structural or secular one. And I think it's important to differentiate because tactically, there could be support for the dollar, especially if the Fed starts hiking rates, even if it is a truncated hiking cycle. So that interest rate differential comes back into play supporting the US dollar. The higher growth dynamics and the higher real yields in the US would also support a stronger US dollar relative to other currencies that are maybe more growth challenged as well. And I also think that the other element from a tactical perspective is that positioning has also been cleared out. I think in general, most people are negative of the US dollar, at least outside of the US, and therefore there's no strong overcrowded long position that could be adverse to the movement of the US dollar.

Finally, I think that it still has that defensive asset characteristic. That sort of safe-haven element continues to be there in periods of significant geopolitics or there's a significant AI risk off. I think that could still be supportive for the US dollar. However, longer term, I think it's much more difficult to make a strong case for a stronger US dollar. And in general, again, it's mainly because those deficits and the questioning of US institutions is still there, because as I said, when you're starting to rebalance trade deficits and trade surpluses, it may mean that there's just less demand for US dollars around. And I think that there's still this anticipation that there's going to be a repatriation of capital away from an ever-increasing amount of US Treasury supply, which could potentially continue to put a dampening on the US dollar versus other currencies. And finally, the reality is that the US dollar is still overvalued in some long-term metrics.

So there's really, kind of from a long-term perspective, a less obvious view on a strong dollar, but in the near term, it could be still supported by some of these geopolitics, some of the positioning elements, and the interest rate differentials that we're starting to see.

Benoit Anne: Perhaps we'll finish with an exciting question. Do you think there's a credit bubble?

Pilar Gomez-Bravo: That's interesting because we keep talking about equity bubbles. On one hand, I can see why that is the case, because spreads have been low and have been contained for a very long time. And in general, like everything, there's an element of whether or not that is a fair value for credit. I think if you look at high yield, where there's actually been an improvement in the quality of the public high-yield markets, I would argue that spreads have been relatively well-behaved within a less than 100 basis points move over the last year. But that market has very short duration and, again, the quality has improved. I think in investment grade, again, I think in general, some of the overall levels of the index don't really give you the sense of some of what's going on under the hood.

So I think that there are some elements that are probably, yes, bubble territory, they're expensive, but I wouldn't say the whole market is in bubble territory, especially because ultimately we have the asymmetry of risk/return. In general, you'd have to see a significant recession or credit deterioration to justify having a significant blow up in spreads. We don't see that for the time being. We see still credit fundamentals being solid.

So it's kind of hard to argue that the valuation of credit is wrong at this point in time, but it does advocate for being selective, because I think that there are some credits that are mispriced, and again, going back to the lower-quality cohorts and private credit where you're probably going to see some incidences of higher defaults. In fact, bankruptcies have been increasing in the US, which is something that we're very cognizant of. And it's just, again, having the analysis to be a lot more selective, concentrate your portfolios a bit more on those credits where you don't feel spreads are too rich.

Benoit Anne: All right. Well, thank you so much, Pilar. That concludes our webcast. Thank you so much for being with us and sharing your insights. Thank you for everyone who joined in. We look forward to the next edition and have a great day, everyone. Thank you.

 

 

 

 

The views expressed are those of the speaker and are subject to change at any time.  These views should not be relied upon as investment advice, securities recommendations, or as an indication of trading intent on behalf of any other MFS investment product.  No forecasts can be guaranteed.

 

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