Fed hawks surprise but credit’s Goldilocks scenario remains
Adam Darling, fund manager, fixed income, discusses last week’s Fed commentary, the credit backdrop and why the bond market may be sceptical about central bank tapering.
Last week’s Federal Reserve (Fed) meeting was more hawkish than expected, and the bond market’s reaction highlights that it does not believe that central banks can tighten in any meaningful way. Short-term interest rates went up as investors priced in earlier Fed rate hikes, but long-end yields, which reflect the fundamental direction of the economy, were falling.
The bond market’s view for many years has been that the global economy is overleveraged, and when central banks try to reflate the economy by pumping in more debt, they increase system vulnerabilities. Central bank talk about tightening through tapering or raising interest rates therefore will just lower growth and inflation expectations. For many bond investors, the view is that growth can only be sustained if central banks are continuously in the market.
Still, many were caught by surprise last week. Central banks had spent most of the year telling the market to ignore the inflation signals, that they are driven by base effects and Covid disruption and that the long-term inflation outlook hasn’t changed. The market was challenging that official view a few months ago when you saw government bond yields back up and reflation trades doing well.
Just as the market was starting to think that maybe the central banks were right, the Fed said, we may need to hike rates because inflation is coming. The uncertainty is creating volatility.
There are signs that President Biden’s spending plans may be getting bogged down in political bickering, and China is continuing to reign in stimulus. Credit growth is stalling in China and a lot of economic indicators are slowing. We expect that to have a negative effect on commodities and global trade dynamics.
There is a lot to think about going into the second half. It is still a supportive environment for credit. It is still a `Goldilocks scenario,’ where economic fundamentals are recovering, government spending as stimulus is very high and monetary policy is very accommodative. Investors are still reaching for yield. US high-yield spreads reached a 14-year low before the Fed meeting, and we have very low default rates forecast for this year and next year.
Credit is very expensive. We expect more volatility as markets get nervous about tapering. It makes sense to be very selective in what you buy. It is a good opportunity to demonstrate the merits of active management.
Did the Fed kill the Value party?
Dermot Murphy, fund manager, value equities, looks at the sharp turnaround in the Value rally last week. Is the Value party over before it really started? Or will any Growth resurgence risk quickly running out of valuation headroom?
The big event in markets last week was the change in guidance from the Fed. It is slightly confusing and counterintuitive that the Fed signalling a rise in short-term rates has caused long-term rates in the market to fall. My fixed income colleagues have explained that this is the market telling us the Fed may have made a policy error by increasing rates too soon which would derail any prospects for long-term economic growth. Yet, if this were to happen it seems to me the Fed could easily change its mind again and bring us back to square one. Luckily, our investment process does not rely on forecasting and so I can leave this speculation to others.
What I can talk about with much greater confidence is the impact this change of guidance has had on equity markets. Growth stocks in absolute terms had their second-best day in over 10 years and there was a 2% relative swing from Value to Growth from midday Thursday to midday Friday – making for painful couple of trading days for Value investors.
Going into 2020 the valuation gap between Value and Growth had never been higher. When the pandemic hit the gap blew out even further, but since the announcement of the vaccines most of that unwound to get markets back broadly to where they were at the start of 2020 – still an historically high valuation differential and wider than the peak of the tech bubble. When we look at the underlying stocks, the majority of the large Growth names are either at, or within 5% of, their all-time highs. If the narrative is that the Value rally is over and we are at the start of another secular bull market for Growth, then it is difficult to see how much further those names can run. It’s notable that the stellar run for Growth over the past 15 years hasn’t been caused by unusually strong earnings growth – it has primarily been down to a valuation re-rating.
Our view is that whatever impact the Fed will have by raising rates, it cannot possibly be as bad for Value as the headwind the style has already faced for the past 15 years, going from the 7th percentile in terms of valuation dispersion in 2006 to the 98th percentile now. This gives us confidence that Value may enjoy more conducive conditions in the years ahead.
The tailwinds driving Asian consumer staples
Jason Pidcock, head of Asian income strategy, discusses interest rates and inflation and why Asia’s consumer staples sector offers many attractive investment opportunities.
I believe that real interest rates are likely to remain negative in many countries around the world for several years to come. This backdrop ought to be favourable for equity income strategies that can yield more than fixed income and can grow their dividends, rather than offering a fixed coupon like fixed income.
While the turnover rate in my strategy tends to be very low, since March 2020 I have been increasing consumer staples exposure, as I like the sector over both the short and long term. In the short term, it is possible to identify many Asian consumer staples companies that are delivering strong growth, with very healthy balance sheets and decent dividend yields. Over the longer term, I believe there are far greater risks for consumer discretionary stocks, as well as many other sectors in the Asia-Pacific region.
Furthermore, demand for consumer staples products is inelastic, meaning that their earnings are relatively easy to forecast.
The consumer staples companies held in the strategy are largely in net cash positions, which makes them more defensive, but I also expect to see capital growth coming from yield compression as people value these types of companies more. Over the next 18 months or so, many countries globally are likely to go through something of a consumer boom – this will be supportive for consumer staples stocks, but also likely consumer discretionary stocks too, as restrictions are removed and people are able to spend the money they have saved, and to travel again. However, after that, I expect there to be more of a “stagflationary” environment, and that is when I believe staples are likely to really perform better than discretionary.
Furthermore, as active, long-term investors, as well as company-specific risks and political risks, we must also consider environmental risks. We have to be conscious of the potential “tipping points” of each of the natural systems that allow the world to function – and I am more comfortable with consumer staples than many other areas from this standpoint, too. I believe that significant change can only really be driven by people freely making lifestyle choices, and that government policies are less likely to have a huge impact on areas like environmental degradation. We must be cognisant of these environmental risks when considering country allocation too, in my view – as such, I choose to have limited exposure to Southeast Asia and the Indian subcontinent, where these risks are potentially higher, and instead prefer to focus on more developed countries like Australia, Taiwan and Singapore (which looks relatively well positioned within Southeast Asia).
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