Nick Maroutsos, Co-Head of Global Bonds, explains why – despite the Federal Reserve’s history of dovishness – higher interest rates are likely to stay in the US. He suggests bond investors need to react accordingly, potentially looking globally for the most attractive risk-adjusted income opportunities.
What are the key themes likely to shape markets in 2019?
The most important is whether the US Federal Reserve (Fed) will raise interest rates at its anticipated pace. Much of what will occur in bond markets – and the economy – will be influenced by the Fed’s actions. While some expect an even more aggressive Fed we believe that, given its history of caution, it will err on the ‘dovish’ side. The threat of an escalating trade war and broader prospect of slowing global growth are two factors that could necessitate a pause on rising interest rates. A second theme could be that higher rates are here to stay. The autumn’s equity volatility did not send bond yields materially lower (i.e. send bond prices higher). While still below historical levels, higher rates could put pressure on earnings and economic growth. The absence of inflation, however, should keep a lid on longer-dated bond yields, with the result being a flattening yield curve. However, a flatter, or even inverted, curve does not portend recession, in part due to lower term premiums.
Where do you see the most important opportunities and risks within your asset class?
We are looking beyond the US for the most attractive opportunities, namely in ‘softening’ economies where central banks are likely to either hold rates steady or lower them; Australia and New Zealand are two examples. With the Fed ahead of other developed market central banks, holding very long-dated US bonds looks risky. Bond investors typically stay within their comfort zones, but we live in an interconnected world and investors can generate attractive returns on a hedged basis when looking internationally. On the credit side, we think quasi-sovereign companies, or structurally advantaged industries, such as banking and infrastructure where – often regulatory – barriers to entry are high, present attractive sources of income generation. The largest risk to markets would be the combination of more aggressive Fed policy coupled with widening credit spreads. An unexpected acceleration in inflation, trade disputes hurting margins and an extended credit cycle are factors that could contribute to such a scenario.
How have your experiences in 2018 shifted your approach or outlook for 2019?
For over a decade we have approached markets with an absolute return mindset and an acute focus on keeping volatility low so as to seek to minimise drawdowns and steadily generate income. In recent years others took a different approach, adopting aggressive tactics to achieve the returns they had come to expect. Often this involved leverage (borrowing) or increasing exposure to lower quality assets. In 2018, we were reminded that reaching for yield does not pay; rising rates and normalising volatility are a lethal combination for leveraged strategies. A faster-than-expected rise in inflation and any corresponding Fed reaction could see an additional shakeout. Given the divergence of prospects globally, both in terms of monetary policy and the business cycle, this past year has also provided us evidence that by judiciously expanding one’s opportunity set, especially internationally, bond investors can still position themselves to meet return objectives without doubling down on the riskiest tools in the toolkit.
Which themes have the potential to redirect markets in 2019?
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Volatility: The rate and extent at which the price of a portfolio, security or index, moves up and down. If the price swings up and down with large movements, it has high volatility. If the price moves more slowly and to a lesser extent, it has lower volatility. It is used as a measure of the riskiness of an investment.
Flattening yield curve: A flattening yield curve may be a result of long-term interest rates falling more than short-term interest rates or short-term rates increasing more than long-term rates. It often indicates that investors are worried about the macroeconomic outlook.
Term premium: The bonus that investors traditionally receive for the added risk of owning longer-term bonds.
Hedged basis: Using methods to minimise or eliminate unwanted foreign exchange risk.
Quasi-national: E.g. state-owned financial and industrial agencies or supra-national financial institutions.
Credit spread: The difference in the yield of corporate bonds over equivalent government bonds.
Credit cycle: The expansion and contraction of access to credit over time: credit availability is often ample during the later stages of a credit cycle.
Absolute return: The total return of a portfolio, as opposed to its relative return against a benchmark. It is measured as a gain or loss, and stated as a percentage of a portfolio's total value.
Drawdown: The difference between the highest and lowest price of a portfolio or security during a specific period.