Mark Nash, fund manager, fixed income argues how his tried and tested Jupiter Strategic Absolute Return strategy that invests in assets across the spectrum is the best answer to tide over a reflationary world following the coronavirus upheaval.
Reflation is the watch word for fixed income investors right now. Last year, central banks and governments around the world unleashed a wave of stimulus to rescue the global economy reeling under the coronavirus pandemic and re-kindle inflation.
As the world slowly emerges from lockdown, thanks to speedy vaccine distribution in major economic zones, concerns over slowdown have given way to expectations of higher growth and inflation. Policy makers and asset managers alike are debating whether the skilled labour shortage in the U.S. and pent up demand for goods are transitory or more sticky.
Given the deep scar the pandemic has left on our economic and financial systems, comparisons with the aftermath of the global financial crisis are inevitable. The post crisis period was marked by low growth, low inflation and central bank dominance. That environment proved very supportive for financial assets. In this falling yield and low volatility world, economic outcomes were poor as central bank liquidity flowed directly into financial assets.
In contrast, the response of policy makers to coronavirus has been much more forceful with governments too joining the ranks of central banks to underpin growth as the scale of the human tragedy unfolded. Hundreds of millions of people are dead and job losses have been widespread as shops and businesses were forced to shut their premises to prevent the spread of the virus.
Governments aren’t likely to end their fiscal support anytime soon as the pandemic has exacerbated social inequality, disproportionately affecting the poorest in our society. US Treasury Secretary Janet Yellen set the tone on the fiscal front in June by saying President Joe Biden should push forward with his $4 trillion spending plans even if that triggers inflation that persists into next year and pushes up rates.
Global warming has also been recognised as a factor that may sustain fiscal support as that has widened social disparity. With Biden at the helm in the US, reducing carbon emissions has once again become a priority after taking a backseat during Trump’s reign.
The good and the bad
Central banks will also remain supportive for longer even if they step back a little, with their main focus remaining on ensuring a healthy banking system to underpin recovery. They may allow excess capacity and fill the GDP gap’’ as the level of GDP is targeted not just growth. We see the recent fear over the US Federal Reserve’s (Fed) potential for early tightening as wildly misplaced and see tapering discussions beginning only in September.
So what does the prevailing environment hold for fixed-income markets? A reflationary environment is generally considered to be good for the global economy. But the same won’t hold true for bonds as inflation typically erodes returns.
A closely-watched measure of inflation expectations in the U.S. — breakeven rates – has risen sharply over the past year. This may call into question the strategy of going long adopted by credit funds during the multi-decade bond bull market. U.S. 10-year Treasury yields are hovering around 1.50%, around 100 basis points higher than the all-time lows touched in August.
Yields may rise further as growth picks up and inflation accelerates. In this context, flexibility in asset selection is important. Experience and a track record of taking both long and short positions are key in this environment.
Our belief is that more traditional credit funds will struggle to make positive returns as the global economy recovers from the contagion and inflation stays above the levels seen in the last decade. That might prompt a tightening of monetary policy.
On the other hand, we believe it makes sense to have a strategy that can constantly reinvent itself depending on the macro environment. The positions we have are aimed at generating a positive return over 1-2 months, which is dependent on market conditions, but the strategy is implemented over a six months horizon on average.
This has proven to be effective in periods of unexpected volatility such as in February when the overall bond market had a bad time as yields spiked. The repo funding crisis of 2019 was another such period.
We believe in using a formulaic construction technique to best express our views and get the position and sizes right. The fund has no benchmark and targets an average volatility in its portfolio construction.
The strategy invests across a wide array of assets including sovereign, corporate and emerging market bonds as well as currencies. We also use derivatives such as interest rate futures, currency forwards and credit synthetic indices, while swaps are used sparingly.
Another important aspect is we don’t take positions for yield purposes but we always look for a price move. We take positions based on our macroeconomic outlook, not just purely because some asset has a decent yield on it. That is especially important for this environment because in a rising yield environment your carry can get eroded very quickly and you can post negative returns.
The liquid nature of our portfolio also enables us to be nimble. If we find our strategy is wrong, which happens sometimes, we try to rectify that early to minimize losses or flip into something that works. Given the macro nature of the fund, we predominantly hold sovereign bonds and avoid low quality credits. That gives comfort for investors but it is also good for us as it gives us a lot of flexibility.
We use top-down fundamental research to identify the macro-economic environment to provide a framework for the core strategy. But the modern financial markets require much more. So we also engage in bottom-up macro analysis as markets themselves can impact economic fundamentals and be key drivers of the broader asset classes.
To determine what is going to happen in broader markets, we focus on US financial conditions, particularly the front end of the interest rate market as well as the Treasury market. What happens in the US has a knock on effect on the rest of the world.
The best forward indicator really is the markets themselves and we study market price actions a lot. Often we know what’s go to happen but it’s difficult to predict the exact timing. For instance, when policy makers were changing course to combat the pandemic last year, we knew credit spreads would tighten, the dollar will fall and emerging market assets will benefit from fiscal and monetary moves. And we watched the market closely to engage all our risk in those manoeuvres.
The value of active minds: independent thinking
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The value of investments and the income from them may go down as well as up and investors may not get back any of the amount originally invested. Because of this, an investor is not certain to make a profit on an investment and may lose money. Exchange rate changes may cause the value of overseas investments to rise or fall. This document is intended for investment professionals* and is not for the use or benefit of other persons, including retail investors.
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Emerging markets risk – less developed countries may face more political, economic or structural challenges than developed countries.
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