Strategic Fixed Income: Concoction of Stress Factors

 In Market and Investment Insights

An unhealthy concoction of factors are creating a classically late-cycle feel in the markets. In a challenging time for bond managers, John Pattullo, Co-Head of Strategic Fixed Income, simplifies the conundrums and shares his views.

Key Takeaways

  • While secular trends have remained entrenched, the last two years have been characterized by a reflation trade, primarily driven by China reflating the world in 2015-16.
  • There is a divergence in equity markets – U.S. growth equities versus European value.
  • There is a clear contradiction in the narratives from the bond and equity markets.
  • Mr. Pattullo believes the technical breakout in yields is more of a false dawn.
  • Mr. Pattullo also believes the unhealthy concoction of factors will prove to be a buying opportunity for bonds in a few months’ time.

This video was recorded on Tuesday, October 9, 2018.

John Pattullo: Hello, John Pattullo here. I want to give you an update on bond markets and risk-managed markets more generally. It is a pretty fascinating time, it is quite a challenging time for bond managers, and indeed wealth managers. The long-term secular drivers that we have spoken about for a long time I think are still in place. You know, the Japanification of the world, the Amazonization of the world, the demographics, technology, all that sort of stuff. And those secular trends remain. The last two years have been characterized by a reflation trade, primarily driven by China (inaudible) dating the world in 2015/2016. That coincided with the Trump election. He took all the credit for it, but of course, China really put quite a bit of monetary and fiscal stimulus into the world and it raised all boats. That stimulus had of course been exaggerated by the Trump fiscal expansion at exactly the wrong time in the economic cycle. And on the back of that, the Fed is set to react really on the monetary side to offset some of the, frankly, illogical fiscal expansion.

Today, we feel it is classically late cycle. It is almost an unhealthy concoction of a number of factors, which I will list in a second, and if these don’t upset the apple cart, frankly, we don’t know what will. So what have we got to do? We have got, well, last week we had a record high in U.S. Dow Jones. U.S. Equity Markets, some are now fading, which I will come onto, but U.S. growth has been a fantastic strategy so far. So you have got high equity markets in some regions, other regions are very weak. You have got a strong dollar. You have got a high oil price. You have got high real interest rates in America and increasingly soon, you have got post-crisis lows in U.S. high-yield spreads. You have got tariffs coming in and you have got flattening yield curves. I mean, what an extraordinarily concoction to slow growth and inflation.

Now on top of that, we have got very divergent equity markets. I have been marketing the states the last couple of weeks as has Jenna. And you have this extraordinary divergence between growth and value, between the leadership in U.S. equities, I am talking has got very thin and very narrow. Predominantly, the hard work is obviously being done in tech, but even that is fading now. And the rest of the world in China and Europe, it has been remarkably weak. And really, the rest of the world equity markets have been fading and falling since the January highs.

Divergence in equity markets between U.S. growth and European value is massive. Now we are not going to say it is going to adjust overnight. Maybe U.S. equities come down to meet European valuations, maybe U.S. growth fades a bit to meet the rest of the world. We think that is a more likely scenario than the rest of the world and the rest of the world equity markets coming up to U.S. valuations. But what is certainly true, and this divergence can continue longer term, there is obvious stresses and strains in the emerging market world, lack of dollar funding, high interest rates, all that sort of stuff is very pertinent and we think will ultimately call contagion to, really, U.S. equity markets.

And I think the extraordinary thing is bond yields obviously have just broken technically. There has been a lot on Twitter about this. This has challenged our view. And we think really it is almost a late-cycle hurrah. We don’t think there is a material breakout of inflation or really in growth…the market would suggest there has been a resetting in what the market considers really is the neutral rate on long-term interest rates. The Fed didn’t say that a couple of weeks ago, but the market has decided there kind of has been this spurt to growth and higher real yields accordingly. Not inflation.

The irony here is, of course, there is an inherent contradiction between what the bond market is seeing and what the equity market is seeing. So higher bond yields and slightly steeper yield curves, you would expect there would be a big growth surge, a switch to value, a switch to financials, cyclicals would perform and so on. But the irony is you are not seeing that. The equity market is getting thinner and more defensive, financials have underperformed, regional financials in the states have performed really quite badly. And as we said earlier, some of the leadership is getting very thin and very narrow. So if bond yields are rising, you would expect financials to start performing and value stocks to come back. We are not seeing that. And as bond managers, we are actually taking some comfort from the rotation back towards defensives in the equity markets to suggest that this bond breakout may be a full storm. And in many ways, this feels like a last hurrah.

Having said all of that, markets test you, they are challenging and there may be a degree of pain. Equity markets may plow on into a Santa Claus rally, that might well happen. But irrespective, I think those concoction of stress factors that I listed, we think will effect activity, U.S. economic activity we think will fade from accepting very high levels. And ultimately, ironically, cash is an attractive asset class short term and front ends are attractive if you are a U.S. investor.

That is why the Fed are putting out rates, they are trying to slow activity, because they are worried about some sort of excessive inflation, which we don’t really buy. But irrespective, we think something will knock the Fed off course, it could well be from EM, it could well be from Europe, such as Italy. Then ironically, cash will become less attractive. Some of the people we follow think the Fed may actually then have to cut rates maybe on the back end of next year and in that environment, I think there is a place for bonds. And you want to be buying duration yet again, not selling it.

So extraordinary backdrop. We have spoken about the secular, the cyclical, the divergence, the unhealthy concoction, and I think we all need a degree of patience and perspective. But as I said, I think this breakout is a false one, I think there are opportunities, we have got to give it a few months to really know what will happen. But ironically, it may be a buying opportunity for bonds, not a selling one going forward.

Thank you very much for listening.

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