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Talking Heads – Finding the best ideas in fixed income

Daniel Morris

In this article:

    The last three years have seen considerable market volatility caused by factors including the Covid pandemic, government subsidies, supply chain pressures, and runaway inflation. After all this, fixed income investors might be forgiven for feeling particularly challenged about how to square the latest trends and translate them into asset allocation.  

    Listen to this Talking Heads podcast about absolute return fixed income investing with Portfolio Manager Abhijit Korde and Daniel Morris, Chief Market Strategist.  

    Abhijit discusses three scenarios for the US economy – a Goldilocks-like soft landing benefiting riskier investments such as corporate bonds; stickier-than expected inflation resulting in a rangebound selloff in risky assets; and a (low probability) recession favouring interest rate assets.

    You can also listen and subscribe to Talking Heads on YouTube and read the transcript.   


    Read the transcript

    This is an audio transcript of the Talking Heads podcast episode: Finding the best ideas in fixed income

    Daniel Morris: Hello, and welcome to the BNP Paribas Asset Management Talking Heads podcast. Every week, Talking Heads will bring you in-depth insights and analysis on the topics that really matter to investors. In this episode, we’ll be discussing absolute return fixed-income strategies. I’m Daniel Morris, Chief Market Strategist, and I’m joined today by Abhijit Korde, Portfolio Manager, Absolute Return Strategies. Welcome, Abhijit, and thanks for joining me.

    Abhijit Korde: Thanks for having me, Daniel. A pleasure to be here.

    DM: What are your thoughts on how the macroeconomic environment will likely evolve, and what are the key factors that might determine how it changes in the months and quarters ahead?

    AK: The key challenge since the beginning of 2021 has been rising inflationary pressures. That has made us think a lot harder, deeper and in different directions about markets and how we manage our funds and strategies.

    For the whole macroeconomic equation, there are three variables: inflation, growth and how central banks [will] react to the dynamics between growth and inflation.

    Before Covid, we weren’t worried about inflation because in developed markets, it was trending at around the range central banks were comfortable with. But post-Covid, we had supply chain issues compounded with a massive household savings cushion, especially in the US, because we had a fairly loose fiscal policy. That meant consumers were willing to spend more. So, both the demand and supply side pointed towards inflation rising, and it did.

    Initially, people thought [inflation] would not be as sticky as it turned out to be, which was what forced central banks such as the US Federal Reserve to tighten policy aggressively. We [are now] seeing some signals of inflation moderating, especially in the last three or four months, with both top-level inflation and other leading indicators pointing towards inflation getting back to its [2%] target range. However, it’s still not there.

    Another factor is growth. This is where it gets interesting, because the central banks look at tackling inflation through monetary policy by reducing demand or growth. What we have seen thus far, in the US more than other economies, is that demand and growth have remained resilient, even though the Fed has done a fair amount of tightening in the last year and a half. After the Fed’s policy meeting in December, [financial markets] interpreted the tone as fairly dovish, and [felt] that the Fed would start cutting rates soon: markets have priced almost six rate cuts before the end of this year.

    In my view, the best way you can think about the macro picture is by doing a scenario analysis, because we know there’s not going to be one particular state of affairs that will play for the entire year. There are three scenarios.

    One is what the Fed has been aspiring to, with inflation on its downward trajectory; it doesn’t completely drop off, it comes down steadily and growth remains okay – so, a soft landing or Goldilocks situation.

    The second scenario is where inflation remains stickier than markets expect because growth remains resilient. Spending remains okay and that keep inflation from falling [further].

    The third scenario is the tail risk one, where the economy falls into a deep recession and the Fed needs to come to the rescue and cut rates by far more than what’s been priced in. But those cuts would take the Fed rate far below the neutral point.

    By considering these three scenarios, you can start assigning probabilities and thinking how different asset classes within our investable universe might behave for a given scenario. These scenarios are in no particular order of chronology or probability and there will be no clear evolution from one scenario to another.

    If the last two years are any guide, we will see a mishmash of these scenarios on a short term or tactical basis. We need to identify for the next month or quarter what sort of probabilities we can assign to each.

    DM: In thinking about what’s happening in the economy and how the central banks might react to that, how do you translate that into market views?

    AK: The [scenario] framework is the starting point, and we can take it case by case. The first case was the Goldilocks one, with the Fed’s aspiration of inflation continuing to trend down and growth remains okay.

    One thing which has changed in the last couple of years, apart from the heightened volatility in interest rate markets, is the correlation between asset classes. Traditionally, riskier assets like equities and credit would have a negative correlation with interest rates or risk-free assets. That has changed because as volatility in interest rates has gone up, it has driven up volatility in credit investments and equities.

    What we are looking for in each of these three scenarios is how the volatility in interest rates is going to function or evolve, and how these correlations are going to change.

    From an asset allocation perspective, that’s an important aspect to consider. In the Goldilocks scenario, one would imagine that if inflation is coming down, volatility and interest rates should trend lower. Whether interest rates would go further than what’s currently priced in is a matter for debate.

    In this context, you would expect riskier investments like equities and credit spreads to perform well. Credit spreads would compress. The total return on those investments would be positive. That’s a scenario where the correlation remains positive in a favourable way – where a rally or positive performance in interest rates translates into positive performance in riskier assets as well.

    The second scenario is where, because growth remains resilient, it puts a floor under how much further inflation can fall, so it remains sticky. That’s a scenario where you would worry about the current market pricing because the market is looking at six rate cuts, expecting inflation to continue to fall.

    If that doesn’t happen, you could have a kneejerk reaction with market participants pricing out rate cuts. That would be a negative signal for holding interest rate risk because yields will rise. It would also mean that the correlation will continue to be positive between interest rates and riskier assets, which would result in a sell-off in growth assets.

    However, because growth remains okay in this scenario, there could be a potential gap in how far the risk assets can sell off. One could imagine a rangebound sell-off in risk assets driven by volatility or continued volatility in interest rates.

    The third scenario is one to which you would assign a lower probability, but it’s a tail risk scenario, the one you need to worry about most, especially from a portfolio construction perspective.

    One of the factors is corporate margins, which have remained resilient. If those margins start coming under pressure, most corporates start reducing their cost base, preferably by reducing their labour force. One can imagine that the Fed would need to come to the rescue by cutting [rates] by more than what’s priced in, so rates would fall to below the current neutral rates.

    That’s a scenario where interest rate investments should perform well because rates have been cut, but growth assets will not do so well because it’s a recessionary scenario. The correlation becomes negative, which is the historical norm. It would be a scenario where you would need to be careful about how you allocate to the riskier part of your investment portfolio.

    DM: How do these different scenarios end up being realised in your current trading strategies ?

    AK: This is the trickiest part of the job because, while it’s nice to have a macro scenario framework of how things might evolve and thus assign probabilities, in reality, markets don’t function in a logical [fashion] or single line.

    We have to keep a careful eye on the risk of the portfolio from a capital preservation perspective, so we are always looking for opportunities to build asymmetry into the portfolio profile. That means when I take a certain position, I have a careful handle on what my maximum potential profit will be from that trade versus how much I can lose. If that ratio is skewed towards the profit side, that’s an asymmetric trade in my mind, and that’s our primary focus from an absolute return perspective.

    One example of what our team feels fairly confident about is the steepness of developed market interest rate curves. By steepness, I mean longer-dated bonds are expected to underperform shorter-dated ones. It works even if inflation remains sticky; if growth is okay, you will still get the longer end selling off more than the short end. So that trade works.

    If you have a scenario where everything moves sideways, you would just have the normalisation of an inverted curve. The valuations at the entry point for that trade are pretty attractive even today.  

    Inherently, a curve trade is a relative value trade. You’re not taking an outright overweight or underweight call on any directional basis; you’re trying to exploit the relative dislocations between two points on the same curve, so your downside risks are limited, whereas you stand to capture a lot of upside. That’s in line with our thinking about asymmetry in risk.

    From a fundamental and valuation perspective, we can also look at monetary policy divergences between some of the developed markets.

    Like the US, the UK market experienced a bout of inflation and the Bank of England responded by tightening its monetary policy. Market  participants are now expecting the Bank of England to start cutting rates at some point this year. In comparison, Japan was going through a situation where getting inflation high enough was a problem until recently. In the last few months, we have seen some pickup in inflation and the Bank of Japan has alluded to tilting towards a more hawkish policy stance. What that would mean for interest rates in Japan is that you would expect [them] to rise.

    So, we have a classic case where in one market, the UK, you expect rates to fall because the central bank is minded to cut rates to prevent a recession from a tighter monetary policy. On the other hand, you have Japan where they still want to raise rates – that’s diametrically opposite to what’s happening in other developed markets.

    This is a case where you have a relative policy difference. Our positioning is tilted in favour of that trade and the way we have implemented it is to have long positions in UK Gilts and short positions in Japanese government bonds.

    DM: Abhijit, thank you very much for joining me.

    AK: Thanks, Daniel. It was a pleasure being here.


    Please note that articles may contain technical language. For this reason, they may not be suitable for readers without professional investment experience. Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. This document does not constitute investment advice. The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns. Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions). Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.

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