‘We’re certainly in uncharted territory,’ says Michael Hasenstab, CIO of Templeton Global Macro. The US-based investor has seen a lot during his career but never this level of intervention.
Hasenstab says the low levels of volatility seen over the past year, thanks to central bank influence, have presented a unique challenge – how do you get an edge when the market is so flat? However, as the Fed starts to fire up its rate hikes, this looks set to change.
‘Central banks have never deployed these levels of QE before, and now the Fed is in an equally unprecedented position of having to unwind those massive levels of QE from its balance sheet. There’s a chance all of that could go smoothly, but we think it’s pretty unlikely – we see a lot of upward pressure building on US treasury yields.’
Hasenstab positioned his sizeable portfolios for rising rates over the course of 2017 and into 2018. ‘We’re aiming to protect against broad market risks associated with rising US treasury yields, but we are also structuring portfolios to potentially benefit as rates rise.
‘There are still good risk-adjusted valuations available, you just have identify the right ones,’ he says. ‘We’re currently focused on specific emerging markets with lower correlations to broad EM beta risks – countries that are more domestically driven and less vulnerable to external shocks.’
Echoing this idea is another formidable fixed income player, Carmignac’s head of international bonds Rose Ouahba. She is poised to capture the diverging fortunes of emerging markets, which started 2017 out of favour.
‘If you look at the likes of Brazil and Mexico, those 10-year bonds have held up well and could continue to do well despite the changing rate environment in the US and we may be able to make tactical gains here,’ she says.
Hasenstab concurs: ‘We’ve been avoiding the low yields in developed markets and instead focusing on specific emerging markets with domestically-driven economies and relatively higher yields.
'The yield differential over US treasuries in countries like Brazil, Indonesia and Mexico is highly compelling on a risk-adjusted basis, and large enough to absorb rising rates in the US.’
Ouahba also used the relative calm of 2017 to alter a position in an unlikely area of the emerging market debt universe, namely Greece. The indebted nation, which dropped from developed to developing status in June 2013, has shown elements of strength and Ouahba increased exposure in Carmignac’s flagship Patrimoine fund accordingly.
‘We reinforced our long-dated Greek positions at the beginning of last year. Over the first quarter we held some shorter-dated bonds and moved into 30-year ones, which did well.
‘We did this in April or May and it was a sound play at the time as other perceived risk assets were doing strongly and also because Greek debt sits outside the scope of the ECB purchasing programme, so it meant paper was available.’
As Ouahba’s comment shows, it is hard to escape the long shadow of central banks. Another common thread was rising geopolitical instability and fixed income investors were on high alert as France and Catalonia went to the polls in Europe, President Donald Trump bedded in and Brexit negotiations trundled on.
Michael Krautzberger, head of European fixed income at BlackRock, was particularly conscious of the perceived radical undercurrent beneath the French election, which pitted independent candidate Emmanuel Macron against far-right contender Marine Le Pen.
‘This is something we could have played differently but still played well,’ he says. ‘We saw that the market response was bigger than expected but that was due to the previous year’s two surprises. People had expected Brexit to go one way and had also been shocked by Donald Trump’s election victory.
‘We followed the French election closely and noticed that investors were reacting more strongly because they had been wrong twice before. However, we always focused on what was going to happen in the second round, as that was the key.
‘We could see it was always 60/40 between Macron and Le Pen, rather than the few percentages between Brexit or not, and Trump and Clinton. For this reason we thought the market was pricing in too much bad news.’
Krautzberger says his ‘softly-softly’ approach, which had small positions sized up cautiously, was more beneficial than a high conviction call. ‘We didn’t go in with maximum positions but sized them up as the environment improved to match our theory.
'We possibly got the timing slightly wrong and that was a minor mistake but ultimately it was positive for the year and, while other managers also made gains here, we were happy with the outcome.’
Low vol redux
For others, the low volatility was reminiscent of previous challenges. Bob Michele, global head of fixed income at JPM Asset Management was among those having flashbacks.
‘The past year reminds me of the 2004-2006 period: low volatility; credit spreads were narrowing and looked expensive; the global economy was reasonably healthy; and central banks were happy to sit back and let things run.
‘This year, while it’s becoming increasingly difficult to find yield, there are still opportunities in the market. Take European banks, for example. European subordinated bank capital notes offer yields in the 4 to 6% range, and these are securities that essentially didn’t exist five or 10 years ago.’
While yields may not be abundant, Michele says there were new parts of the market worth exploring. ‘One of the features of the fixed income market in 2017 compared with previous years was the lack of anything notable; it has been relatively “smooth sailing” across markets and sectors, highlighting the weight of central bank balance sheets.’
So, how have the top managers stayed ahead of the pack? Olivier de Berranger of French group La Financière de l’Echiquier, says flexibility has been more important than ever before. This was particularly true when it came to duration, as there was no need to be drawn out into wider duration during a time of market uncertainty and rising rates.
However, Bill Adams, CIO for fixed income at MFS, disagrees. ‘We are still in the low interest rate environment that has dominated much of the past few years and most of the post-financial crisis period. This “lower for longer” environment is something we have adapted to and was very much part of our thinking throughout 2017.
‘That said, we have seen a co-ordinated, global cyclical uptick in economic activity for the first time in the post-crisis environment. However, structural factors are likely to keep rates lower with more limited expectations for rate increases.
‘We believe interest rates should be slightly higher than current market pricing given the global growth environment. We are not proponents of the bond bull bubble bursting and we think investors are better served in keeping some duration in their portfolios.’
These comments were originally published in the Bonds & Beyond supplement which came out in February 2018.