‘Don’t fight the Fed’ has been a long-standing mantra for many bond managers, but even playing by the Fed’ s rules comes with pitfalls, as JPM Asset Management’ s Bob Michele discovered last year.
Michele, the company’s CIO and head of global fixed income, currency commodities, positioned his multibillion-dollar portfolios in expectation of fast-rising US rates throughout the course of 2017. The reality, however, proved different.
‘We expected a move higher in rates, particularly in the US, but these higher yields haven’t materialised,’ he says. ‘We attribute this to three factors: the more muted inflation environment, the effect of global central banks continuing to expand their balance sheets, and a lack of fiscal policy from the US administration.’
To soften the impact, Michele took a more diversified approach and made better use of credit and emerging market exposure as a result.
He will be now watching closely as Jay Powell, the new Fed chair, gets into his stride in February, but remains mindful of the need for a wider perspective.
‘Going forward, we’re much more aware of global monetary policy rather than getting too focused on any particular central bank. We’re also watching for the point at which central bank balance sheets change tack from expansion to contraction – and importantly when the market begins to price this in.’
Rose Ouahba, head of international bonds at Carmignac, was similarly wrong-footed as the European Central Bank ate up market share and the Fed impacted the strength of the dollar.
‘Our dollar hedge was not that great last year given its performance against the euro. When it went to 1.12 and 1.15 we assumed this was a temporary move but it turned out to be the way the currency was going.
‘Because of our hedge we suffered in assets where we had dollar exposure. We also expected moves associated with the French election and a supposed rise in volatility, but our predictions on parity didn’t pan out. Going into 2018, euro strength is likely to be a big challenge for the portfolio.’
Ouahba, who manages the bonds sleeve in the €22.7 billion Carmignac Patrimoine fund, thinks questions around rates will remain a priority for global bond managers.
‘The biggest challenge on the horizon is European core rates which are set to change as a period of easing moves towards tightening. Risk premia pricing has receded against a backdrop of growth exceeding expectations this year.
‘The output gap is closing as well and the move towards a normalisation on rates has begun. Even with all these factors in play we want to stay away from core rates, despite the accommodative measures that remain. The ECB still holds 19-
20% of the outstanding debt in Europe, and although this is likely to change, we are still watching valuations.’
The speed at which central banks pull back from the market could have important implications for overall liquidity, says AllianceBernstein veteran Gershon Distenfeld (pictured).
Distenfeld, who is director of credit and a portfolio manager across billions of dollars of high yield funds, thinks investors are overlooking the importance of liquidity.
‘Retail investors ask us about how the market is likely to react to such volatility when it happens? I get calls asking if I am going to sell XYZ and I reply with the question: “well, are you going to sell?” We need liquidity and the ability to liquidate but no fund manager would automatically sell to achieve that, it would have to be an investor’s decision.
‘In that sense the marginal buyer is now the retail investor. So what can we do? If you ran a high yield fund the way you did 10 years ago, you’d be asking for trouble, so you need to consider liquidity.
‘We have around 10% of the fund in liquid assets, not necessarily cash but short-dated debt, and we also sell CDS protection, which provides a shield for us.’
So, what else can Distenfeld do to stay in step with retail investors? Increasingly complex investment ideas are being used to unlock yield, but Distenfeld has a warning for those seeking short-term gains while long-term problems persist.
‘We don’t wander into areas which are perceived as liquid because there is a market. You may end up selling at a price which is unfavourable just to offload it, so you have to question why you went into it in the first place. We are sticking to our strategy of watching for the opportunities that come from dislocations in the market,’ he says.
BlackRock’s head of European fixed income, Michael Krautzberger, is equally cautious. The London-based manager is keeping close to benchmark allocations to avoid unexpected moves caused by a shift in central bank policy.
‘We now have around 50% in sovereign debt and an average rating of A-, compared with an A rating in the index. We differ and add value through our international exposure, where we can express plays such as the Canada/US trade or make a move on US inflation through the 10s and 30s. Not every trade will always work but we are staying nimble.’
Echoing comments by Michele, flexibility looks set to be a driving factor for 2018 and the use of global flexible ideas is likely to form a cornerstone of Krautzberger’s investment thinking.
‘We’ve seen a growing appetite for unconstrained ideas and have been following this approach for about 10 years,’ he says.
‘Investors want diversification and this is a useful tool to limit the correlation they are experiencing by moving into higher-risk assets. If we have a correction then those who have piled into high yield, EMD and bank loans, for example, will all be hit in the same way. We want to mitigate that risk so we diversify across many positions.’
Michele is taking a slightly more defensive stance than his counterparts as we enter 2018, albeit having capitalised on some attractive investment opportunities as the previous year came to a close.
‘We are mindful of a pending shift in this technical support and we are likely to reduce risk at some point in 2018. This move is not imminent, so we are not taking risk off yet and instead have used the dislocation in credit markets at the start of November as an opportunity to add risk, specifically in global high yield and European subordinated bank capital,’ he says.
These comments originally appeared in the Bonds & Beyond supplement which was published in February 2018.