Global Perspectives Podcast: An extreme hatred of bonds… just or unfair?

Adam Hetts: Welcome back to Global Perspectives. It’s time for another update with John and Jenna. Of course, John Pattullo and Jenna Bernard are Co-Heads of Strategic Fixed Income here at Janus Henderson and this conversation continues a series where we’ve been leaning on their clear thinking to demystify all these violent moves in the rates and spread markets. And last time we spoke was September. We left off with John and Jenna concerned about base effects and a hawkish central bank leading to rising rates and with them looking forward to an opportunity in 2022 to go long duration once again. So far, so good, I’d say. And before we get into 2022, Jenna, I think we can start with that base effects concept and I think your team’s rate of change model is helping take that base effects concept and drive it towards a more practical response. So, can you start simply by explaining what we mean by base effects and why your rate of change model is so important right now?

Jenna Barnard: Yes. OK, so if we step back and think about movements in government bond yields, which I think confound so many people, what we have found over our careers that what really drives the direction and intensity of government bond yield moves is not the absolute level of economic data. Whether that’s inflation or growth or unemployment, not the “level,” which is the way central banks think and economists think, but really the rate of change, i.e., the kind of second derivative of the data. Is it accelerating at a faster pace or a slower pace or indeed, is it decelerating? And the bond market is so clever and so pre-emptive because it reacts to these shifts in the rate of change of the data, the pace of acceleration. And that’s why we so often see policy errors in central banks who are hiking at the peak of the cycle because they’re looking at levels of economic data even after the data is decelerating quite fast.

So, that’s the kind of framework through which we think about duration, moving duration and government bond exposure in the portfolios cyclically. That’s the kind of road map we’re trying to trace. And what’s happened post-COVID is that you’ve had, you’ve essentially had like this simultaneous heart attack across the global economy, this incredible collapse and growth in inflation in the spring of 2020, and that created base effects, which have echoed through a year later. And again, a year later after that and created these amazing kind of inflection points for growth and inflation when it’s measured on a year-on-year rate of change and allowed us to move the duration of the portfolios around quite aggressively and with a good amount of success. So, when we’re thinking about base effects, it’s the reference point for comparison between two data points. If you think about inflation, that’s always measured as a year-on-year rate of change. So, the rate of inflation the year before that you’re measuring off, either gives you very easy or very difficult base effects to beat. So that’s all we’re talking about. And as I said, COVID was such an unusual situation that unlike these kind of normal quite slow economic cycles, which take a few years to trace out, we’ve had the echo of the huge base effects. First, the collapse of growth and inflation, which created really, easy base effects for a year later when growth and inflation surged – helped by reopening of economies, driven by vaccines and fiscal stimulus. And then that creates very difficult base effects this year to beat and so the economy is going to feel like it’s decelerating quite fast. We lap through those come this spring. So, I mean we’ve written a paper about this if people are actually interested in the details of our model and the way we think. We published that I think in November last year so you can read more about that.

But the one thing I would say about this approach is it doesn’t work in every year or in every type of economy. As I said, normally, there’s a quite long cycles. Some years, you don’t really have any big impulses or base effects compared to the previous year and there’s not much doing. But we found it a really kind of fertile and helpful way of thinking about navigating this very strange post-COVID environment that we’ve all lived through in the last couple of years. So that’s the way we’ve been using that approach and thinking about it and we think it’s kind of one last trade this year. That deceleration that we’re coming up against based on base effects in the next few months as inflation starts to come down very rapidly, growth has already peaked last year in most economies, but it’s not just the base effects that we’re going to be facing in the next few months. We’ve got fiscal tightening, we’ve got monetary tightening, we’ve got energy prices squeezing consumers [in Europe] and we’ve got the peak in the inventory cycle. The most incredible inventory build we’ve seen for many, many cycles has peaked and will start to detract from growth. So actually, I could list you kind of five headwinds to growth and inflation as we progress through this year. And we’re really at odds with this consensus narrative that bond yields are going to go up because central banks are tightening. I mean that tightening to us is like a policy mistake and we think bond yields will follow the deceleration of growth and inflation, not the potential policy error of hiking at the short end. So that’s how we kind of set up as we enter this year. And yes, is that a helpful summary of how we’re thinking and the framework?

Hetts: So, Jenna, you’re talking about energy prices being up and inventory bottlenecks and those are of course, inflationary factors, but you don’t seem as concerned about inflation, so can you square that for me?

Barnard: So, if you think about it, I mean U.S. inflation is peaking at 7%, just over 7% headline inflation, this month/next month. UK inflation could peak as high as 7% come April/May, depending on what happens to energy bills and government involvement. And that will be the peak year-on-year rate of change and inflation is going to collapse because of those base effects primarily from there through to the end of the year. And I think really, the debate is how fast is that collapse, and where does inflation bottom? Because then we can get a sense of what is the structural, trend level of inflation, you know? So, I wouldn’t say the debate in bond markets is whether inflation comes down, it’s just mathematically going to. It’s a question of how far does it come down, and how fast – that’s really the question mark that’s out there.

And that’s an inflection point. You know, we’ve had this whole narrative – early 2021, we had this reflation narrative, growth and inflation were both surging then growth peaked and came down, but inflation surged again, so you had a stagflation narrative. What we’re going to go into is growth and inflation decelerating. That will be a slowdown narrative. So that’s what we’re talking about. These rate of change inflections can really affect the narrative that you hear in markets. But it’s not one of outright deflation as we sit here today.

Hetts: So, I think that’s a good recap of where we’re at with inflationary pressures and base effects. And then Jenna, you mentioned fiscal and monetary policy. So, John, maybe I’ll ask you. How do you think about the base effects and inflationary views coming up to coincide with the Fed soft landing or hard landing? And what opportunities are you expecting to result from that side of things?

John Pattullo: Sure. Well firstly, I would say of course, if the Fed did this job right, we probably wouldn’t have a job. So, you know, this stuff’s not easy. Economics you know, is an art and because they do frankly, make policy errors, that gives Jenna and myself opportunities to make money for our clients. The Fed are in a real pickle here because you know, they completely underestimated the persistence and size of the inflation shock and they were under a degree of political pressure because inflation was just so high. You know, as we’re saying earlier, it’s a tax on less wealthy people and it’s frankly, unfair. And then thirdly you know to be fair, the employment market is massively tighter than anyone forecast. You know, could be due to these early retirees and people in childcare and extra student study and all that sort of stuff. So, you know, that employment market is really tight. So, on both mandates, they’re breaching; both mandates if you’d like – too much inflation, unemployment too low. And then they’re still doing QE, yes. Other central banks around the world have moved before them, which is frankly most unusual because you know, like the Bank of England or something, normally follow the Fed, not vice versa. So, they’re in this pickle as they have to get rates up pretty quick to knock that so-called level on inflation on the head, which they will do because they’ve said they’ll do that and they’ll do that and they said that that’s going to happen in their minutes. But they’ve got to be pretty careful because if they raise rates too fast, they would you know, cause a hard landing and they almost just have this window of tightening, which is very short because you know, the second half of this year as Jenna said you know, growth and inflation will be fading. And the worst thing you want to be doing is raising financial conditions into an economy, which is frankly, growing less fast. So, I think the chance of the so-called perfect soft landing is almost minimal. Invariably, no Fed governor wants to be the person who let inflation out of the you know, inflation genie out of the bottle, which invariably means you probably have to over-tighten and then reverse, pivot back the other way.

You know, monetary policy has long and variable lags as Milton Friedman told us all. And I’ve got two analogies for you if you like, Adam. The first one is literally you know, a moving brick, you’re trying to slow down with a bit of elastic and you know, you keep pulling the elastic and it’s not slowing, its not slowing till it kind of you know, snaps and hits you in the face – snaps. It snaps back, actually the brick comes back to you or literally, it’s like you know, landing a jumbo jet or an aircraft carrier is very, very hard to do with the sole policy of monetary policy. And hence, the chance of it going wrong is pretty high. And hence that obviously would change our, we would change our asset allocation and duration interest rate sensitivity quite materially, subject to how the market reacts to the Fed’s policy reaction. They are behind the curve by purpose but now they’re so far behind, they almost have to jump ahead and catch up with the market and they’re in a tough position. And you know, I guess you’ll never see so much fiscal and monetary stimulus ever again – you know, hopefully in our lifetimes, because it was a kind of war if you like. It was a wartime response to COVID and you know, I think everyone’s, frankly, lacking a bit of experience on how to manage that on the other side.

Hetts: Okay, so, we’ve got the brick and the elastic band on policy and inflation and rates. Then what about the credit side of things? We’ve been talking rates, I think, this whole time for the most part. So maybe you can catch us back up from the back half of last year to what you two are watching going forward on credit.

Pattullo: Yeah, I mean credit is not the villain here. You know, I think everyone sort of fights the last war. You know, the banks are well capitalized and frankly, lending fairly sensibly. Credit markets are reasonably well disciplined. Leverage has creeped up, of course. You know, there are some froth around, but nothing like from what we’ve seen historically. So, you know, credit is not the villain. It’s broadly reassuringly expensive, it’s definitively late cycle. There’s a bit of so-called event risk kicking off in like you know, corporate agitators and Unilever and other companies and that’s a threat to investment grade bond holders. The high yield market is fairly benign. I mean normally, there’s a few stress sectors in high yield. Normally, it’s energy but obviously, that’s sort of sorted itself out with the massive oil price and restructuring and energy’s obviously been a top performer recently. And then the final point of default rates are so unbelievably low. I mean default rates are 1% or thereabouts and forecast to stay around 1%. I mean historically, that’s just unbelievably low. So, credit is really you know, it’s the kind of residual, what’s going on everywhere else, if you like.

What we have seen most recently and actually, there’s two research reports out today from the investment banks saying that the beta of how fast credit has sold off to equity, this recent equity market volatility spike is, as Jenna and I thought, really quite low and quite muted. Really, because it’s more about you know, valuations and underlying earnings and cash flows. You know, so I don’t think there’s going to be a default spike or anything like that, but yes, valuations might back up a little bit as the Fed raises the front end of the curve and flattens the curves. You know so eventually you know, holding cash or holding short bonds gets more attractive relative to high yield. So, it’s pretty benign. It’s reacting with a fairly muted beta to risk elsewhere, principally because default rates are so low and we don’t see much systemic risk in the credit markets.

Just, sorry, just saying we have thinned our high yield and our investment grade exposure a bit through the back half of last year because it’s just getting classically late cycle. That would then give us an opportunity to add risk as and when and occasionally, Jenna and I do trade credit synthetic indexes because they’re massively liquid, very efficient and cheap to trade and it means you know, we can play, add or subtract credit beta without getting tied up in the underlying bonds on a tactical trade and that’s worked pretty well as it did into the Omicron spike in November/December there.

Hetts: Is it fair for me to link that to the rate side then, that you’re looking for you know, Fed activity, base effects, inflation to create that volatility on rates this year? But credit for lack of a better term, is sort of fair where it’s at so you’re not so pessimistic or optimistic on credit. You’re just not seeing a whole lot of opportunity for movement there, even…

Pattullo: And you can play to those vol spikes as and when they come using derivatives and that’s what we’re did. I know Jenna’s got a view on the credit interest rate beta as well, haven’t you?

Barnard: Yes, I mean definitely investment grades asset class is really sensitive to rates vol. Rates volatility as you would expect. Investment grade’s you know, high quality credit, which prices off government bond yields. But what we found with high yield as an asset class as John kind of referenced earlier, it not being the villain of the piece in the way it was in the last couple of cycles. Credit’s really been moved around by these, the volatility in equities and it feels a bit like U.S. equities are the villain of the piece this cycle. You know, the optionification of the U.S. equity market and these incredible VIX spikes we see every few months, these volatility spikes. I mean it feels like credit is obviously a risk asset and high yield is getting moved around in sympathy with some of the just extreme positioning retail involvement option market activity that’s now dominating the U.S. equity market. It’s really a remarkable situation. So, yes, we would expect volatility in credit and some tactical opportunities but you know, we can’t point to any fundamental credit catalyst beginning of any default or distressed cycle in credit as, it’s just not there. I think defaults for high yields ended 2021 at an all-time low, didn’t they John, of just under 1%? It’s just remarkably low default rates. And the kind of forecast we see and the level of distress in the high yield market at the moment would suggest that those low default rates are set to continue, at least for another year. So, it’s not really credit we worry about, it’s I suppose, the U.S. equity market and what’s going on there, seems to be a bigger factor.

Hetts: Well, since you’re talking equities, maybe a bonus question on credit here and with the equity conversation being dominated by the cyclical trade. In the past, I’ve heard you two explain that you avoid the “asset-destroying cyclical sectors” in your bond selection. So, how do you square your avoidance to the cyclical sectors that are asset destroying with just the broad optimism on cyclical sectors in the equity reflation trade?

Pattullo: Well, I mean it’s logical. We’d completely understand it and the floating boat, you know, rising tide floats or boat, but don’t dress up bad businesses or cyclical businesses having a rally, with anything more than just a beta rally. And as I said, we can just play that using credit derivatives. You know, because it’s a beta trade in our opinion; so, we have to have enough beta keep up with you know, your value, reflation trade if you like.

Hetts: I think that covers it. Anything else we should discuss before we tie this one off?

Barnard: I mean I suppose the final point would just be that as bond fund managers, we kind of, we hope and pray for an opportunity or a set-up like we have today in government bonds. You know, central banks way behind the inflation curve, panicking about the level of inflation as it peaks. And yet, we can see they’re heading into a sharp deceleration of growth and inflation. I mean that kind of set-up, that kind of potential policy error and the linear narrative that you hear in markets that yield’s going higher because central banks are hiking, I mean that is the opportunity that we just hope for and we sit around. It normally happens every couple of years doesn’t it John, or maybe every four or five years, but this is… This is quite exciting for us as boring bond people, this kind of cyclical set-up. So, I would really caution against this kind of lazy hatred of bonds and this lazy thinking that because central banks are hiking, longer-term bond yields are going higher. It just doesn’t work like that. It’s not that easy. And if anything, you’re heading into what looks like a really sharp inflection point to the downside for growth and inflation this year. So, and I should say positioning in the market reflects that extreme hatred of bonds. You know, the sentiment, the positioning you know, these are kind of max underweights of duration out there and it’s all looking a bit late and a bit as I said, a bit lazy. So that would be the only kind of final point from us, would it, John? I don’t know. Do you want to add anything?

Pattullo: Yes, no, that’s really good. That’s a great conclusion.

Hetts: Yes, I think that actually counts as a nice dose of optimism from a couple bonds managers. So I agree, that’s a good note to leave on. So yes, thank you both again and I always come into our conversations thoroughly confused by the environment and leave, with you two making it sound like it’s actually pretty simple, so thank you.

Barnard: Thanks, Adam.

Pattullo: All right, take care. Thank you.

Hetts: And thanks everyone for tuning in. If you haven’t already, you can find us on Spotify and iTunes. Please like and subscribe and we look forward to bringing you more Global Perspectives soon.