Fixed income: Looking beyond market direction | Insight Investment

First of all let's take a look at inflation the geopolitical environment certainly heightened risk there as i'm sure everybody knows but looking a bit more carefully the subtleties here if you look on the left hand side compared to where we were in march when the conflict started where the line there shows a spike and then a decline in energy prices there's much more expectation of longer term higher prices now shown by that latest orange line for energy costs going forward and equally on the right hand side it's not just about energy costs um taking here broader shipping costs are way higher than they were before the conflict began so definitely some issues there to address.

And also it's not just about energy prices i mean showing here you've got the er us inflation numbers for core pce goods and services those are also quite high um and on the right hand side similar story in the ecb plenty to in europe sorry for the ecb plenty for the ECB to be vigilant on. Then moving forward to the growth environment well what's going on here first of all pmi's looking pretty solid um above that 50 mark so generally growth holding up pretty well in this environment.

Also corporate earnings um this continued upward revisions for corporate earnings on the left hand side and if you look on the right hand side this hasn't been fully reflected in equity prices yet so a pretty robust picture all round there. Then looking at the labor market in the us well know job gains have declined we're still not in contractionary territory so again this will give the fed confidence all of these things together will to er be on the hiking path you would think.

But then if you start looking beneath these head 9 numbers it's a slightly different story there's a big difference between for example here the tech and other sectors in terms of their growth numbers and if you turn over to the next page consumers are also facing with these higher food and energy prices confidence beginning to reduce and so the fed won't want to overdo things with the hikes particularly when you consider the inflation numbers i showed you earlier there is a subtlety there for all of these reasons that yes they are higher than the fed's comfort zone but we're not expecting inflation because of some of these things i'm showing you here to really accelerate from levels that they are at currently.

In europe it's a similar story there's bifurcation here of growth this time it's not about tech necessarily but there are other sectors such as defense as shown here where growth is relatively strong and to some extent the sectors holding up the rest of the economy which is relatively weak.

So what are central banks going to do off the back of this well we do expect the central banks to hike but not as much as the market expects since the inflation rates while high are unlikely to run away from here and also the underlying fragility of large parts of the economies as i mentioned despite those headline numbers will keep the central banks relatively in check so if you look at the left hand side chart here in the box there are our forecasts for 12 month rates um uh compared to where the market is pricing things and you can see that we're yes expecting hikes in general but not as much as the market is priced in so potentially some opportunities there in shorter maturity fixed income.

Another factor affecting things of course is debt sustainability issues much talked about um looking at these charts here you can see look the direction of deficits between um you have different governments relative to gdp is pretty high and in particular there's a number of countries really not looking so great on this measure as shown on the left.

To make this potentially even more volatile is many markets are held or bonds are owned to a significant extent by non-domestic bondholders who tend to be less shall we say sticky which can also add to volatility in these markets and this is certainly the case for 2 countries showing the biggest debt to gdp issues here both the us as shown on the right hand side here and also of course france much talked about they have significant overseas holders relative to global indeed european peers as shown here.

All of the implications of all of this and the opportunities of course to decide what we want to see here and what we want to do rather we look at what's already priced in by the market.

First of all the overall duration for you now although there's been a lot to worry about as i've talked about already we think that the rise in yields this year as a result of that the market has significantly priced in this worry in fact we would say it's slightly overdone these concerns and we're now starting to see value in bond markets by slowly going long duration or leaning into these rising yields and this is reflected on the box in the left hand side of this page where if you see our fair value 12 month forecasts in the left hand side of that box on the right hand side if you can compare them to what the market forwards have priced in the brackets generally speaking we see value and potential for yields to fall a little bit from here over the next year.

But it's not just about betting on market direction i should say especially as that's not always a good opportunity from time to time it's very important when you're running fixed income portfolios to have a whole range of different relative value metrics that you look at examine closely across the market and in depth into all the different areas of the market sectors to highlight opportunities to really get good diversification of the positions in your portfolio so let's at a few examples of where that's interesting today.

First of all japan now looking here again there's inflationary pressures of course but when we look at what it's priced in for example on the right hand side with jgb yields and where they head relative to us yields on a hedge basis they still look relatively attractive and in fact if you showed this in 30 year bonds even more so and we'd certainly see some value on a relative basis in longer maturity japanese bonds particularly when you think as we showed earlier that some of the big holders of us treasuries are in fact japanese institutions so there's potential for some of that to be repatriated or for marginal flows to be directed domestically as a result.

Turning elsewhere of course there's much talked about france showing here as i'm sure many of you know the significant spike up in french yields uh for all the well publicized reasons in the press recently um now whilst we would still have a relatively cautious or negative view on how things are going to play out over the medium term in france for all the well discussed reasons we would caution that again you have to be careful what's in the price and also be nimble and be aware of events that could come up not least the french budget over the next er month or two which can cause this line to move down a little bit as well as up so that might give better opportunities for significantly increasing a bearish view for example and indeed what we'd also say is there are potentially other opportunities away from just government bonds where they might be better value at the moment and i emphasize at the moment to express that relatively negative view on france in the medium term.

Elsewhere in europe there's certainly opportunity in other markets for playing relative value i mean for example on the left hand side we note that the swedish economy is relatively strong and we expect the riksbank to start hiking before the end of the year and in addition to that when you think about swedish corona rates should probably have some sort of relative liquidity premium to uh to buns for example we see some value in going short there versus funds and conversely on the right hand side we'd note that yes while the australian economy or rather inflation concerns are strong and therefore warrant some degree of high yields when you consider that relative to us yields we think again there's a little bit too much priced in and there's opportunity as we've thought for a long time for australian yields to outperform but we think that can still continue for a while yet at current levels.

Coming closer to home to the uk we also feel that you know as well of course the uk has its own issues fiscal challenges to deal with relative to what's priced in for the us in terms of long bonds versus shorter dated bonds we do see some potential on a relative basis for the uk to flatten versus us relatively speaking amount of flattening that could happen there so in other words we would expect that right hand side chart to move much more in favor of a flattening relatively speaking or the line to continue to go down.

The other hand you look away from regular bonds to say inflation bonds well again there's some opportunities here we'd note that although inflation pressures in both markets exist as discussed the sustained level of inflation we would say in the us should be higher relatively speaking but that's not reflected in these two lines here showing the price implied for inflation or the relative levels of inflation implied by inflation swaps so we would expect those us inflation-linked swaps to outperform their euro counterparts going forward.

That's the rates outlook and some examples of where we see um opportunities in rates but what about credit well here look we summary at top of this slide of the framework we use the short version of that is look cos i briefly touched on earlier the growth environment is still supportive and actually given where we are at moment with yes all right elevated inflation and real rates rising the combination of all of that has historically generally been supportive for credit markets and for risk markets in general.

But if you then look at what's priced in on the bottom left hand side for example spreads versus government bonds are still historically tight despite the recent small widening um so if you're allocating from government bonds to credit bonds it's still not a hugely exciting switch to do but on the other hand in the bottom right hand side with where yields are overall those do look historically attractive so if you're allocating from other asset classes to uh bonds in general be it credit bonds or government bonds and that does look relatively appealing so that's just a subtle difference between those two aspects that people will be looking at.

Again it's also worth noting that probably because of those yields that i showed you in the bottom right of the previous chart flows have generally been pretty robust yes they've come down a little bit in euros but they're still decently positive and they continue to be so in the us so fund flows continuing to come into credit markets and credit related funds which suggests the technical picture is pretty constructive.

Then I mentioned that some other places where the risks in europe could be better reflected or better value a notable one here though is if you're saying europe if you're saying that overall the credit markets don't look particularly exciting from a value point of view relative to government bonds one place you can add value we think particularly if you want to reflect that cautious view on france or broader europe is here in for example credit spreads for europe versus investment grade so an underweight in europe versus the us could be relatively attractive we'd think.

Equally also there are other ways to express that we would note look on the right hand side the financials again we'd expect that sector to underperform the broader euro market it has done bit of that already but there's potentially a bit more to go for there and on the left hand side equally also the part of the way we're going now in uh the credit markets more and more risks appearing in certain areas of the high yield market number one creates a great opportunity to be a stock picker a bond picker within high yield and we have strategies that do that and exploit that but equally also it gives you the opportunity we would say to be shorting the generic indices in high yield which of course are equal weighted and not discriminating between the good and the less good in the high yield universe.

Then of course there's AI related issuance again a much talked about subject well the good news here is that the sector still creates opportunities to outperform the market for credit investors mean first of all you take the hyperscales here as shown on these charts the sheer volume of projected issuance even allowing for us on the left hand side a greater share of equity being involved means that although generally they have solid credit worthiness there's certainly a significant supply demand issue to be aware of and then to exploit particularly when you consider that look if projections prove to be true by 2030 around then there'll be around about 10% of the overall credit market so certainly something to exploit and certainly something that cannot be ignored.

With that in mind with other things equal this justifies wider spreads for that wider sector and while we've seen a little bit of that already we will see opportunities to short the generic indices which again are not discriminating between the winners and the losers leading to wider spreads in those relative to the market but equally also as it's starting to get towards that place now with obviously the moves you've seen to potentially invest a bit more in some of the potential winners in this area and either way of course that creates opportunities for security selection in the market to be exploited by active investors such as ourselves so that's all good news

Therefore in summary as usual it's not about using just overall direction or should we be long durations should we be long credit spreads and hoping those work it's about looking through all these different levels of detail in the market and these quadrants reflect that uh for example on the left hand side in rates yes directional positioning is starting to be attractive now but again it's important to look at relative value between different areas different countries different parts the yield curve and inflation bonds similar story in credit on the right hand side the directional attractiveness of credit is pretty close to neutral at the moment but again there are lots of opportunities on the relative value side whether it's between different currencies different parts of the market or different sectors or of course as i've touched on there exploiting the winners and losers in all these different areas of the market.

Conscious that time is moving on so i'll leave you there but hopefully that's given you an introduction into some of the many things that we are looking at and getting involved in over this quarter so thank for listening um and look forward to speaking again soon and i'll now just take you through the necessary er disclaimers er and so on at the end of the webinar.