Rates, Recession and Generating Alpha in Fixed Income: Four Views
Rates, Recession and Generating Alpha in Fixed Income: Four Views
Ariel Bezalel, Alejandro Arevalo, Hilary Blandy and Luca Evangelisti discussed inflation, investment and the macro outlook, at Jupiter’s September conference.
Investment Manager & Head of Credit Research, Fixed Income
Is inflation here to stay?
Ariel Bezalel, investment manager, fixed income: Cycles don’t end by themselves, cycles typically end when the US Federal Reserve (Fed) puts a bullet in them. I think the Fed is about to put several bullets into this cycle. Chairman Jerome Powell is determined to break the back of inflation and to not repeat the mistake of Arthur Burns (Fed Chair 1970-78) who took his foot off the brake prematurely and allowed inflation to run out of control again.
We have concerns about housing globally and China. In China, we think there has been a permanent step change down in growth. China has an enormous credit and housing bubble. Demand for housing is set to drop, the government in China is in a bind and that has implications for global growth. We also are looking at other countries where housing bubbles are starting to pop as interest rates are going up – including Australia, New Zealand and the US.
For these reasons, we believe we are set for a hard landing. If you look at over 100 years of data, recessions have caused inflation to come down on average by nearly 7%. We think inflation will come down swiftly in the next 12 months as the US economy goes into a serious recession. I don’t think much of this is priced in.
Hilary Blandy, investment manager, fixed income: The market has consistently underestimated inflation this year and I see a couple of risks there. The first is a discrepancy between what you see on screens and what you hear about in real life. Prices may be coming off their peak but are still well above pre-pandemic levels. The companies we speak to are telling us that they are putting their prices up and will continue to do so. Also, labour markets are incredibly strong in the US, Europe and UK. That has resulted in high levels of wage growth. Ultimately wage growth will sustain inflation and so it will be difficult for inflation to fall without wage growth also falling. We are coming from such a position of extreme strength and tightness in labour markets that it may take longer for wages to fall back down to that 2% level that central banks need.
Alejandro Arevalo, investment manager, fixed income – EMD: In this cycle, one thing that is interesting is that some central banks in emerging markets started to tighten rates well before the Fed. They tried to be ahead of the curve. In Latin America, they were very aggressive, and you have some positive real interest rates. Brazil and Mexico have reached or are very close to the end of the rate tightening cycle.
Luca Evangelisti, head of credit research and investment manager, fixed income: Rising rates are what banks have been waiting for. On one hand you get higher revenues as margins widen but on the other, banks could see an increase in asset risk in coming quarters. But the banking sector in Europe is now in a place that we have almost never seen before in terms of balance sheet quality. Banks have been deleveraging ever since the global financial crisis, selling underperforming loans. European banks’ non-performing loan exposures have gone from 4.5% of the total five years ago to below 2% currently. After years of central bank easing and zero-interest rate policies, bond financing for corporates has become much cheaper than bank financing. As a result, there has been a shift in risk from the banking sector to credit markets, therefore banks remain in a good place fundamentally to absorb potential shocks.
We have concerns about housing globally and China. In China, we think there has been a permanent step change down in growth. China has an enormous credit and housing bubble. Demand for housing is set to drop, the government in China is in a bind and that has implications for global growth. We also are looking at other countries where housing bubbles are starting to pop as interest rates are going up – including Australia, New Zealand and the US.
For these reasons, we believe we are set for a hard landing. If you look at over 100 years of data, recessions have caused inflation to come down on average by nearly 7%. We think inflation will come down swiftly in the next 12 months as the US economy goes into a serious recession. I don’t think much of this is priced in.
Hilary Blandy, investment manager, fixed income: The market has consistently underestimated inflation this year and I see a couple of risks there. The first is a discrepancy between what you see on screens and what you hear about in real life. Prices may be coming off their peak but are still well above pre-pandemic levels. The companies we speak to are telling us that they are putting their prices up and will continue to do so. Also, labour markets are incredibly strong in the US, Europe and UK. That has resulted in high levels of wage growth. Ultimately wage growth will sustain inflation and so it will be difficult for inflation to fall without wage growth also falling. We are coming from such a position of extreme strength and tightness in labour markets that it may take longer for wages to fall back down to that 2% level that central banks need.
Alejandro Arevalo, investment manager, fixed income – EMD: In this cycle, one thing that is interesting is that some central banks in emerging markets started to tighten rates well before the Fed. They tried to be ahead of the curve. In Latin America, they were very aggressive, and you have some positive real interest rates. Brazil and Mexico have reached or are very close to the end of the rate tightening cycle.
Luca Evangelisti, head of credit research and investment manager, fixed income: Rising rates are what banks have been waiting for. On one hand you get higher revenues as margins widen but on the other, banks could see an increase in asset risk in coming quarters. But the banking sector in Europe is now in a place that we have almost never seen before in terms of balance sheet quality. Banks have been deleveraging ever since the global financial crisis, selling underperforming loans. European banks’ non-performing loan exposures have gone from 4.5% of the total five years ago to below 2% currently. After years of central bank easing and zero-interest rate policies, bond financing for corporates has become much cheaper than bank financing. As a result, there has been a shift in risk from the banking sector to credit markets, therefore banks remain in a good place fundamentally to absorb potential shocks.
Fixed income investing in a period when yields are rising
Ariel Bezalel: Fixed income markets have been dull for the last few years and are now looking the most interesting they’ve been in quite some time. As our view is we are entering a pretty serious recession, so we would expect government bond yields – for example, US Treasuries — to roll over in the next few months. In corporate credit, we expect to see some really good value, particularly in the lower end of investment grade, triple-B rated. You are getting credit from high-quality businesses with a spread that is pricing in fairly recessionary conditions. Within high yield, in double-B, with defensive credits like telecom and cable companies, you can get 6-, 7-, 8-year paper offering 7%-8% yields, secured on assets. If our views were to change and we felt that there would be more inflation volatility longer term, then we have tools to deal with that. Using derivatives, we are able to manipulate the duration lower if we felt that was necessary. This is something we have done in the past.
EMD, CoCos and credit from a historical valuation perspective
Alejandro Arevalo: The last time valuations in emerging markets were this low was end 2015, 2016 when oil was at $30 a barrel. If you have a long-term mentality, it is very hard to ignore this asset class. There is a dislocation between valuations and fundamentals. It is very difficult to time the market. I believe it makes sense to start exploring, to look at the yields, to look at that differentiation between value and fundamentals because in the long term you will get paid for that. When we look across the EM asset classes and we look at the Sharpe ratio, which measures returns against volatility, over the last 10 years EM corporates have been the outperformers. Even now when there is so much volatility they have continued to outperform. There are some corporates that operate in macro environments that are very challenging, and they tend to be penalised for that. Some of these companies are very well diversified and often much of their revenue comes from outside their home country. As an investor, that can offer you the premium in which you are paid for that risk. I believe it can be a good source of generating alpha.
Luca Evangelisti: CoCos (contingent capital) have been unduly punished this year. If you look at the index, it’s down around 18% year to date, one of the largest drawdowns we have seen. Unduly because as I said, the state of the banking sector, the quality, is the best it has ever been. On a historical perspective, the yield on CoCos is around 10%, that is the highest yield we have ever seen in this asset class. The spreads are around 540bps which is only comparable to the beginning of 2016, but the rate environment was very different, and banks were in a worse position. So, the sector is trading very cheaply. In historical performance terms, if you had invested in 2016 when yields were at a similar level, for the following two years, the sector returned almost 30%.
Hilary Blandy: The monthly income strategy is yielding around 7%, almost double what it was a year ago, and that comes with a higher quality credit profile. As yields have moved higher, we have migrated up the credit spectrum and the strategy holds less high yield than a year ago. In recent months I have seen attractive opportunities in short-dated investment grade bonds — buying blue chip names with low duration risk and where the risk of default is incredibly low. Even in longer duration assets, 10-year gilt yields are four times higher than they were a year ago. Across fixed income your entry point now offers a much bigger yield, and that is a nice cushion against any downside risk in the short term. Over the longer term if rates or spreads return to their historic averages, that would represent a double-digit total return opportunity.
Luca Evangelisti: CoCos (contingent capital) have been unduly punished this year. If you look at the index, it’s down around 18% year to date, one of the largest drawdowns we have seen. Unduly because as I said, the state of the banking sector, the quality, is the best it has ever been. On a historical perspective, the yield on CoCos is around 10%, that is the highest yield we have ever seen in this asset class. The spreads are around 540bps which is only comparable to the beginning of 2016, but the rate environment was very different, and banks were in a worse position. So, the sector is trading very cheaply. In historical performance terms, if you had invested in 2016 when yields were at a similar level, for the following two years, the sector returned almost 30%.
Hilary Blandy: The monthly income strategy is yielding around 7%, almost double what it was a year ago, and that comes with a higher quality credit profile. As yields have moved higher, we have migrated up the credit spectrum and the strategy holds less high yield than a year ago. In recent months I have seen attractive opportunities in short-dated investment grade bonds — buying blue chip names with low duration risk and where the risk of default is incredibly low. Even in longer duration assets, 10-year gilt yields are four times higher than they were a year ago. Across fixed income your entry point now offers a much bigger yield, and that is a nice cushion against any downside risk in the short term. Over the longer term if rates or spreads return to their historic averages, that would represent a double-digit total return opportunity.
Outlook for fixed income over the next 6-8 months
Ariel Bezalel:Credit selection is key. Also, short-dated paper has to make up a core part of your credit book at this juncture. The other thing we are buying is senior secured paper, where we are secured on assets, typically tangible assets – cable networks, telecom networks, property – to help underpin the value of the bond. We are also favouring more defensive sectors given the fairly treacherous macro outlook. Finally, we are focused on inflation, but be aware that there has been something like 300 rate hikes globally over the last 18 months. There is a lot of tightening coming through the pipeline, and that tells me that the global economy is going to slow down sharply. We think government bonds are starting to look quite interesting, particularly at the long end of the yield curve.
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