Fixed Income in Focus: Are the Hawks Back?

Benoit Anne:  Hello, everyone and welcome to our Fixed Income in Focus website, Global Perspective. My name is Benoit, and I’m the head of market insights at MFS, and I’m joined by Pilar Gomez-Bravo, our co-CIO of fixed income. So Pilar, are the hawks back? That’s the title of our webcast. So we had a number of central bank meetings over the past couple of weeks. We had the ECB with a rate hike, we had the Fed with the new Fed chair, we had the Bank of Japan, the BOE. So, let me start with this. What’s your view on global monetary policy, and what does that mean for global duration view overall?

Pilar Gomez-Bravo:    Yes, indeed. I mean, it’s a great title. I think that it’s clear to us that the global monetary cycle has shifted. Last year, it was a year where you‘re seeing cuts from most central banks, some with delays, some not. But basically, what‘s happening now is that all the banks that had cut are now hiking. All the banks that were still left to cut, like the Fed and the Bank of England, are probably on hold. And even some of the emerging market banks where you were still expecting significant cuts, maybe you still have one or two left, but again at the margin. That monetary policy shift is probably likely to persist, even the expectations of what Warsh was going to be have shifted. And in fact, in fact, it‘s mostly because the labor market data has not supported that dove-ish-ness to come through and because of anything, obviously inflation is a little bit sticky.

But now that that monetary policy cycle has shifted, it‘s really difficult to see it reverse quickly. We wouldn‘t expect that to revert back in the next couple of months. As you head into the end of the year, you obviously have the elections in the US, which are going to dominate the headlines and maybe put that sort of Fed perspective more into play. But for now, we would anticipate that the real decision-making with regards to duration in your portfolios, within the context that most central banks are fairly priced, is really, do you really believe that you‘re going to get more than two hikes out of the Fed? Do you really think that you‘re going to get more than one and a half hikes from the ECB? And which markets have the strength of the domestic demand to withstand the growth impact from a much higher monetary policy?

And lastly, but surely, especially with the Fed change and forward guidance, is to what extent are us as investors going to do the work of the central banks? Are we going to time monetary policy so the central banks have to do less? And so there, I would advocate that we all need to focus a lot more on the yield curves and the country valuations rather than overall directional duration. I think it‘s a little bit more nuanced now. Overall, you don‘t need to have a very strong, long position in duration or short position in duration, but you can be a little bit more nuanced as to where you want to take your duration and which country and in which curve.

Benoit Anne:  Yeah. And so follow up on that. I know there‘s a lot of nuance there, but do you have topics or do you lean in certain markets and maybe be funded by other markets there? What‘s the global duration landscape the way you see it right now?

Pilar Gomez-Bravo:    Yeah. I mean, there‘s lots of opportunities when you have a global horizon, an investment horizon. So, things that we‘re thinking about right now. So we had a position where we were long eurozone against the US in terms of duration. We‘re wondering, how much more does that have to go? We‘ve seen already a big move in that. So, do we want to still keep that and which part of the curve do we want to keep? We probably think that maybe, given Warsh‘s comments, that maybe we‘ve seen the peak in long-end rates. So, do we still want to have the position in 10s and 30s, which is tended to be more underweight with the steepener. We still think that the 2s–10s flattener in the US might work, but maybe we want to have more of a steepener position. We still like Canada, for example, as a country to take duration risk in. We‘re looking at Australia, which is another market that has already hiked three times.

So there‘s plenty to do, even within the context of local emerging markets and which of the diversified central banks you want to have exposure there still, including things like Brazil.

Benoit Anne:  Yeah, yeah. Let‘s talk about global risks. There‘s no denying that the list of global risks ahead of us is pretty broad and diversified. If you had to single out or highlight a few key risks on your radar, what would those be?

Pilar Gomez-Bravo:    Yeah. Well, I have to commend you, because you engage with all the fixed income portfolio managers once a quarter and ask us a very clear question, which is, what are the top three risks in your mind over the next 6 to 12 months? So it‘s very easy for me to talk about the risks that the fixed income platform sees because you already do quite a lot of that anonymous heavy lifting for us.

Not surprisingly, the risks that we see as fixed income investors are always most and foremost about growth and inflation trade-offs, and now it‘s all about inflation. Right? So, I think that is still the biggest risk. If you think around the next 6 to 12 months, the big risk that we see is still inflation, right? And how long is it going to last? What are the second-order effects that we have to worry about? And are the central banks going to still be holding out because of the second-order effects that might come through?

The second one obviously is geopolitics, which is still there. Although frankly, we‘re always worried about geopolitics in fixed income, but obviously needless to say with Strait of Hormuz where it is, these things are still not resolved properly. And so, we worry about the supply shocks that might still have to be perceived in the context of the Middle East conflict, as well as the fact that there are other conflicts in the world that we‘re still worried about, as well as the fact that you‘re going into political cycles in the US later this year, in France next year. And so, I think that that is still there.

And finally, one area of risk that we continue to see is around AI, not just with regards to the supply in fixed income that we‘re experiencing, but more importantly around equity market fragility, because I think a lot of the consumption that we‘re seeing, particularly in the US, is driven by that higher-income cohort, which is driven by equity market. And so, we worry that there is an equity market correction that is significant enough to cause us concerns around growth and deceleration of growth across the world.

So, those are the risks that we‘re seeing, is the AI and everything that‘s linked to AI, including private credit, the inflation, and obviously the geopolitics with regards to demand destruction.

Benoit Anne:  Yeah. That creates complexity, of course, and uncertainty, and in principle that supports the case for active management, which is our job to navigate. Another big job that you have is to navigate the valuation landscape in fixed income, and it‘s fair to say that valuations look a bit stretched in many markets. So, how do you deal with that, and where do you see the most compelling opportunities right now in global fixed income?

Pilar Gomez-Bravo:    Again, having, being able to go anywhere in the world in search of mispriced risk premia helps as an active investor. And I think that it‘s really difficult to argue that credit is cheap, in any version of credit, whether it‘s public or, I would argue, also private. And that puts perspective on how much do you think the fundamentals are going to carry through — actually carry through the portfolio — and where do you want to have the carry, effectively. If you don‘t believe that there‘s a significant amount of compression opportunity in spreads, whether you‘re in EM or high yield or investment grade or Europe or the US or emerging markets, then you have to think about holistically about how defensive is the carry that you‘re getting? Because carry is notorious for working until it doesn‘t.

So I think that in that context, having diversification is key, and making sure that again, that if you don‘t have the valuation anchor, which by the way, there are still parts of the market that offer opportunities in certain sectors within certain asset classes. But from a top-down perspective, I think it‘s more about, how do you construct the risk in the portfolio so you have that diversification with conviction views? And the opportunities are there. For example, there‘s certain parts of the short-duration high-yield market in the US that still seem attractive within certain sectors. I think in IG, you might be able to construct certain barbells that create value, and emerging markets, where we‘ve been focusing more, is on that crossover space. In the mortgage side, we‘re not seeing huge amount of value in all the new deals necessarily in the CMBS, but occasionally we‘re finding some parts of the interesting areas in mortgage derivatives that create value as well.

So, you can construct pockets of carry in the portfolio, with some opportunities in certain sectors or using credit ideas from the analysts, that give you that compression opportunity, including EM, where you still might have that sort of compression because some spreads are still tight. So it is about putting the puzzle pieces together to create that sort of “carry versus compression” opportunity but not have to be over your skis in beta. And so it‘s all about defensive carry, but that still keeps you getting the yield and relying on the still relatively decent fundamentals that exist, not just in the US but generally around the world, where we don‘t expect recession risk to come through anytime soon.

 

 

Benoit Anne:  Yeah. Of course, your job is always to look for some dispersion or some disconnect, and you just mentioned sectors. Are there any particular sectors that pop up on your radar that offer, that have maybe veered away from the middle of the pack, or is that how you think about it, or is it more of a security selection process?

Pilar Gomez-Bravo:    It‘s a well-rounded process, so we think about it in many different lenses. I mean, I think that if you take a very high level, we think about fundamentals, valuations and also technicals, right? In fixed income positioning, supply demand is important.

I think that with regards to sector specific, there are certain markets like the investment-grade market where sector dispersion is not that high, but you might have more dispersion between US and euro investment grade, right? In high yield, you have a bit more dispersion, but that‘s mostly driven by quality, where we wouldn‘t advocate having to go down deep into overloading the portfolios and triple Cs, but there may be some sort of differentiation in certain sectors in high yield that might be more impacted by the software and the AI trade in the high-yield side.

Where have we been looking for more interesting opportunities in sectors? Well, energy has been a sector that since the Strait of Hormuz has become more and more interesting for us, because we know the tailwinds from the earnings are going to be positive, and the valuations were relatively attractive compared to other sectors. We‘ve been increasing our exposure to certain debt from certain BDCs that are preferred by the analysts. So, that‘s a combination of security selection with a sector theme of dislocations, right? Within AI, we would rather talk to the different portfolio managers in the different asset classes to say, “where can we get the best bang for our buck within an AI unit of risk,” right? And it could be with certain project finance type of deals, rather than just a 30-year investment grade.

So, I think it is a combination of some sector defensiveness with regards to still preparing financials up in quality, still liking utilities, liking energy, not liking necessarily super cyclical names like autos. But really working deep with the analysts to identify, okay, within those themes, where are the best opportunities from a security selection perspective and an issuer selection?

Benoit Anne:  Yeah, we‘re going to keep with the theme and now maybe look into an overview of how, what would be your positioning bias in your global multi-sector mandate, if that makes sense.

Pilar Gomez-Bravo:    Yeah. So again, within that global context, if you think about the three key themes or markets that we express uses kind of rates, asset allocation and FX to some extent, although we don‘t take a huge amount of FX risk in our portfolios. With regards to rates, we‘ve been going a little bit more underweight over the last several months in terms of overall duration, but not majorly. As I mentioned, expressing more positions in certain markets where we might have a little bit of the long end in the JGB market but still underweight in Japan, but we might still be adding some sort of front-end exposure in Australia, but not necessarily taking up duration. So the bias is to be slightly underweight to neutral duration overall in the portfolio, but really try to stress more the country and the curves, as I mentioned earlier.

I think with regards to asset allocation, we continue to favor credit carry, and so we remain still overweight, although not maximum overweight in some of the credit exposures. We tend to still be probably under exposed to high yield relative to the neutrals in the different mandates that we manage that can buy high yield. But what we‘ve been asking is to get a little bit more of yields from our high yield exposures by working with the analysts on extracting more concentration and conviction in some of these short-duration parts of the high-yield market.

And in emerging markets, we tend to prefer more sovereign risk, not necessarily because we don‘t like the corporates, but we think that we‘d rather at this point in time favor liquidity. We want to be the providers of liquidity when and if there is a correction in the market, and obviously fixed income‘s over the counter, so we need to preserve liquidity within the portfolios. So within emerging markets, that sovereign exposure gives us more liquidity than corporates. And we prefer to have a little bit of more crossover exposure within emerging markets than be up in quality. So, we still have a bias to favoring investment grade relative to high yield and being able to have more of that [inaudible] exposure.

Mortgages, we‘ve been using as a source of funds. We don‘t think that rates fall can come down much more than it has. So therefore, that is another element that doesn‘t put us into having a lot of mortgages in our portfolio. We‘d rather fund other, more interesting opportunities from the mortgage capital that we‘ve had and the exposures there.

And finally, one of the things that we‘re thinking about is, we‘ve been for a while now underweight US dollar to varying degrees, is looking to maybe reduce that underweight a little bit, given the changes in monetary policy dynamics, and the fact that a lot of people are still quite bearish the US dollar.

Benoit Anne:  Oh, very good. Well, we had a number of client questions, so I selected two of them for your consideration. Well, we could just start with the oil price. Do you think the oil price can go back to its pre-Iran war level of around $60?

Pilar Gomez-Bravo:    I mean, eventually I think it can, but it really depends a lot on obviously what the resolution is to the Middle Eastern supply shock. I think if you started the year, you started the year with this expectation that one of the drivers of policy from the White House was bringing down energy costs, right? Amongst the five pillars of policy that maybe we thought with regards to immigration, tariffs and other things, energy was one of them. And so we started the year with this expectation that you were going to be below $60 potentially by the end of the year, especially going into an election year, and also because of supply, right? Supply glut that we were going to have in LNG and oil.

This has been distorted by what‘s happening now with physical access to the commodity itself, and that‘s still unclear whether it‘s going to get resolved or not. If you assume the most optimistic case, that everything goes back to normal immediately, you may be able to get to a position where the forward contracts are pricing in that sort of level of oil, but I think it‘s really difficult to see that happening quickly, just because of the whipsawing of headlines around what‘s going on in the Strait of Hormuz. So I think that again, in fixed income, we have no upside and we have a lot of downside, so we‘d rather make sure that that sort of expectation of transit through the Strait of Hormuz is there, and that inventories are replenished. And then, obviously the latest reports from the international agency do show a glut of supply. And if you do think that there is some degree of demand destruction that has resulted from either monetary policy tightening or the oil price, then you would expect lower demand and higher supply to lead to a lower oil price.

So, I think that the direction of travel is for lower oil, but it doesn‘t mean that tomorrow we don‘t have a headline that pushes oil higher, and it‘s that path that is really difficult to call, even if in the long term you would argue that once this gets resolved, you go back to a position where oil price comes down.

Benoit Anne:  Yeah, very good. Another question is about the US dollar and I know you touched upon this earlier, but with the Fed being a little more hawkish, does it fundamentally change our view on the US dollar going forward?

Pilar Gomez-Bravo:    I mean, I think there‘s two elements. There‘s a secular narrative, and then there‘s a cyclical one, right? I think from a cyclical perspective is what I was mentioning, that maybe reducing some of that underweight in our case in our portfolios makes sense, mostly because of the DXY is showing a bottoming of positioning, and so pretty much everybody‘s still bearish. But that really is more reflecting the euro–dollar pair.

And going back to the discussion that we had earlier on about the different monetary policies that are being pursued, I think there is a case to be made, especially with regards to growth expectations. Look at the PMIs that came out of Europe this morning, were quite weak, is an expectation that maybe that growth differential plus the monetary policy differential, where maybe the ECB can‘t really do a lot more, but the Fed can, is that would point to maybe having a bit of a stronger dollar. So cyclically, we‘re inclined to add US dollar exposure. I think those secular themes are still there though, and I would caution about being really overweight secularly the US dollar because I think that some of the elements that are still there hampering the strength of the US dollar are probably still going to likely be there. But from a cyclical perspective, I would say yes, that we‘re more comfortable with adding dollar exposure.

Benoit Anne:  Well, excellent.

Pilar Gomez-Bravo:    And also, I think because it helps as a risk off. So you have the two things, is that all else being equal with regards to risk-off perspective like we saw in March, it at the margin would also support having a little bit more dollar.

Benoit Anne:  Well, excellent. Well, thank you so much. That concludes our Fixed Income in Focus webcast. So, thank you Pilar. And dear clients, if you have any follow up questions for us, please don‘t hesitate to reach out, and we‘ll be delighted to get back to you. Thank you very much.

 

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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