Strategic Fixed Income: End of the Cycle … Are We There Yet?
John Pattullo and Jenna Barnard share their thoughts on the idea that global economies are in a late-stage cycle, expanding on the risks and opportunities for 2019.
- The key theme in 2019 is prompted by the question: When and how will the cycle end?
- While the managers believe we live in a much less inflation-prone world, they also believe there is a small but unlikely possibility of a sudden acceleration in inflation, leading to aggressive rate hikes by central banks.
- The key opportunity is the fact that the economy is in a late-stage cycle. If true, as the cycle turns, there may be opportunities in quality government and investment grade bonds.
What are the key themes likely to shape markets in 2019?
John Pattullo: I think the key themes for 2019 is really the answer to the following question: Is it the end of the cycle and how is it going to end? 2018 has been classically late cycle, in our mind, of a very long cycle, and hence really a test of, Is growth going to fade? Was the Trump fiscal expansion a sugar rush or was it something more structural?, which we’re skeptical of. Is inflation going to come through? Which, again, we are pretty skeptical. And then, what’s going to happen to global demand, and growth and inflation, respectively, and hence which asset class do you want to position accordingly?
Where do you see the most important opportunities and risks within your asset class?
Jenna Barnard: The key risks for bond investors is a sudden acceleration in inflation, either consumer price inflation or wage inflation, to which central banks react aggressively. In our mind, we think we live in a much less inflation-prone world. With the oil price coming off at the end of 2018, obviously that is helpful for headline inflation, but the risk really is central banks that are itching to normalize interest rates, take them back to a level which they consider more normal in order that they can cut them in the next recession. So far, the only central banks that have managed to do that are the US Federal Reserve and the Canadian central bank. For many reasons, other central banks in the developed world have struggled to raise interest rates. So the risk to bond markets is inflation taking off and some central banks being given the opportunity to raise rates more aggressively.
In terms of the credit market, the risk is that it’s late cycle. There has been a huge deterioration in the quality of companies that have been raising debt, the amount of debt they’ve raised, the use of proceeds and, if John’s right or the market’s right, in indicating that it is very late cycle, then obviously credit is going to suffer in the next asset price correction.
The opportunities are that it’s late cycle. That is the most difficult environment for a bond investor because credit spreads move wider — they tend to … credit spreads tend to lead the equity market peak — and bond yields and duration is very choppy and difficult to make money. So in a late-cycle environment, you can’t make money, either, in credit, particularly, or in government bonds. If it’s late cycle and the cycle turns down, in the next phase, you can make money as a bond investor through quality government bonds and quality investment-grade bonds, and you can make quite a lot of money.
How have your experiences in 2018 shifted your approach or outlook for 2019?
Barnard: I think throughout 2018, we were working under the assumption that it was late cycle, and we saw that through multiple asset classes: the oil price melting up, lack of breadth in the equity market, flatness of the yield curves in the government bond market, credit spreads beginning to widen, real yields spiking higher … so, every asset class to us was kind of ticking the late-cycle check list. With the equity market sell-off in October, with the oil price crashing in October 2018, I think we got additional confirmation that it’s ‘later’ late cycle. I don’t know if you want to add anything?
Pattullo: Yeah, no, definitely. I think it is definitively late cycle. But I think that, yeah, you need a degree of patience and perspective of that fact. And we have to accept that. The clients have to accept that. And for a while, cash would outperform and short-duration bonds would outperform. And then the correlations with equities potentially falling, bond yields will start falling as well. And I think as the peak of rates is realized by the markets, as Jen said, the opportunity there is to get long duration in quality bonds, and you can make capital again.
So. I guess it’s not just a calendar year that you have to be patient for. You may need to see it through the year-end. You may get a rally into Christmas in equity markets, which may drag up bond yields. If that’s so, we’ll probably extend duration, because we think this sugar high is not going to last and growth and inflation have peaked, and that you just have to position yourselves and your clients with you accordingly and tell them what you’re doing. And then get the rewards of that. As in when they come, just sometimes you ‘ve got to be a little bit more patient than maybe you thought you had to be. But as long as you communicate that, I think that’s really where we are as a management team, aren’t we?
Bond yield: the level of income on a security, typically expressed as a percentage rate. Note, lower bond Yields mean higher bond prices and vice versa.
Credit market: a marketplace for investment in corporate bonds and associated derivatives.
Credit spread: the difference in the yield of a corporate bond over that of an equivalent government bond.
Duration: how far a fixed income security or portfolio is sensitive to a change in interest rates, measured in terms of the weighted average of all the security/portfolio’s remaining cash flows (both coupons and principal). It is expressed as a number of years. The larger the figure, the more sensitive it is to a movement in interest rates.
Inflation: the rate at which the prices of goods and services are rising in an economy. The CPI and RPI are two common measures.
Late cycle: asset performance is often driven largely by cyclical factors tied to the state of the economy. Economies and markets are cyclical, and the cycles can last from a few years to nearly a decade. Generally speaking, early cycle is when the economy transitions from recession to recovery; mid-cycle is when recovery picks up speed, while in the late cycle, excesses typically start to build, growth slows, wages start to rise and inflation begins to pick up. It is often in the late stage that investors become overconfident.
Fixed income securities are subject to interest rate, inflation, credit and default risk. As interest rates rise, bond prices usually fall, and vice versa. High-yield bonds, or “junk” bonds, involve a greater risk of default and price volatility. Foreign securities, including sovereign debt, are subject to currency fluctuations, political and economic uncertainty, increased volatility and lower liquidity, all of which are magnified in emerging markets.
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