Welcome to Word on the Street, a weekly podcast from Barclays where our experts help ordinary investors make sense of the latest news and events impacting the world's financial markets.
Chris Bamford, Portfolio Manager, talks to Mark Dowding, Chief Investment Officer at BlueBay Asset Management, and Jean-Paul Jaegers, Head of Asset Allocation, about the role of high-quality fixed income within diversified portfolios. They also explore inflation, labour markets, the latest expectations for interest rates, and what it all may mean for investors.
Chris: Hello, it's great to have with us today, Jean-Paul Jaegers (JP) and Mark Dowding, who are with me to talk about the high-quality fixed income market.
Now, many of our listeners will be very familiar with Jean-Paul, who's a regular contributor to the show. However, most will not be familiar with Mark, who is a Senior Portfolio Manager at BlueBay Asset Management, and looks after government bond strategies amongst others, and is also Chief Investment Officer.
So, we are absolutely delighted to have you with us today. So, welcome.
Mark: Well, thank you for having me.
Chris: To kick things off, JP I'd really like to start with you and ask you a little bit about how you see the role of high-quality fixed income in multi-asset portfolios. And really, I'm speaking about government bonds here primarily. But typically when I'm speaking to clients at the moment, there's been a lot of concern over what has happened over the last 24 months. The rationale for holding high-quality fixed income has been tested, thinking about income, diversification, and capital preservation. From your perspective, JP, why should clients continue to think about high-quality fixed income in a multi-asset context?
JP: Hi, Chris. Hi, Mark. So, that's a very good question. So, despite all the pain we have seen in fixed income, why hold fixed income? That's a question we regularly encounter as well. So, in a multi-asset account, if you think long-term, then the risk premium you get for owning government bonds is actually quite unique in addition to an equity risk premium or credit risk premium, which was challenged not too long ago when we were close to zero-rate interest rates. Long-term, we know that the starting yields of government bonds often are an okay predictor of long-term returns.
The starting point today indicates that fixed income govvies still have a place in a multi-asset portfolio. Also, remember, if we have a multi-asset portfolio, some assets will hit a period or a drawdown at some times. So, for example, a couple of years ago we did see that commodities were not very popular and suddenly they did very well in recent years. We always explain to clients, “well look at the whole portfolio holistically and see whether it delivers as expected, as there will be plenty of counterfactuals and intra-portfolio dependencies”, meaning that some assets might do better when others hit the pothole.
Chris: Great. I suppose one of the key challenges that has faced fixed income investors over the last couple of years has been this rise in inflation, which fortunately we're starting to see come down over the last sort of 12 months. But more recently perhaps that's stabilised and there've been concerns about the oil price and potentially what do we see from here? So before I come to you Mark, JP, what are we seeing? What do we think with regard to that trend?
JP: As you say, inflation has been one of the central themes, and although the direction of travel, if you look at the trend, is moving in the right direction. But, of course, we need to be mindful that inflation could remain a little bit more stubborn and a little bit more volatile. Yes, central banks have increased policy rates significantly, and policy setters are focusing on inflation. But remember that the control policy perceivably has on inflation remains a bit elusive.
We had a long period of disinflation and low inflation with a lot of policy working in an opposite direction, and it took almost a decade to get away from zero interest rates. So, although we think it will move to target over time, the profile remains rather uncertain.
Chris: And Mark, would you agree with that? I mean, are you concerned about the uncertainty around inflation, the variability, and sort of the levels that we get to?
Mark: Yes, I think that we would express that degree of concern. I think we are living in a fundamentally uncertain world at the moment and in our interaction with policymakers like the Bank of England, there is some ongoing angst around inflation as it stands today. At the point of recording, we've just seen the latest news on UK inflation still remaining about 6% on a core basis. And so with that being the case, that's needing interest rates to stay relatively high for the time-being in order to bring inflation down. And certainly there has been a sense where, after the pandemic, there was an easy part of the inflation journey may be bringing inflation down from 10% down to 5% or 6% today.
That was partly because we saw very high inflation after the pandemic because of disruption to supply chains in things like, we saw that in second-hand car prices, didn't we? But moving forward from here, I think the rest of the journey in terms of bringing inflation back from 6% towards the 2% target that the Bank of England and other central banks will adhere to, the next part of the journey could be a more challenging, a more difficult last mile, so to speak. And so from that point of view, I don't think we can afford to be complacent about inflation just yet.
But I also think we can say that the worst of the news on inflation is very much now behind us.
Chris: Fascinating. And I get the sense you don't think the UK is going to follow a vastly different path to the US. That a lot of these major economies are going to be driven by a lot of the same trends?
Mark: I think that that is right. Though I think one of the things that we have observed in the UK is that inflation in the UK has been at higher levels than it has been elsewhere globally. It is actually an interesting observation and we've pointed out to the Bank of England that when we meet with other global central banks, often we talk about inflation being too high – that's the narrative very much in the media. But here in the UK, we seem to focus much more on the cost-of-living crisis. And this is kind of an interesting distinction because it does mean that the response to that has been to push wages a bit higher.
So, notwithstanding the fact that the UK economy seems to be slowing down, maybe struggling, we are seeing wage growth remaining relatively elevated even as the labour market weakens in the UK. And we are concerned that inflation could stay stuck at higher levels in the UK relative to what we see elsewhere in continental Europe or in the US for that matter.
Chris: And I suppose that does bring us on to talk about labour markets, which I guess is the other key area that central banks have been focused on and thinking about. We're obviously living in an environment with very tight labour markets at the moment. JP, turning to you, are we seeing any signs on our side of labour markets softening?
JP: Well, we see that the unemployment rate, for example in the US, has been inching up ever so slightly. We see job creation remains very resilient. It sort of indicates the labour market remains quite hot. We see, in the UK, unemployment inching and the labour market inching up and softening a little bit further. But as Mark just alluded to, we see that wage growth has been holding up quite well there. But this is in the context where central banks have increased policy rates very significantly in a short space of time.
So it's a question and a little bit where markets are looking at whether that is the beginning of something more or whether we get the so-called perfect soft landing where unemployment just weakens just enough to not have inflation as the number one concern.
Chris: And on that soft landing concept, I mean the market from a pricing point of view has shifted a little bit away from those recessionary fears that were dominating things earlier in the year towards that idea that potentially central banks can engineer some form of soft landing.
I mean, do you think it's realistic to expect, given how far they've had to move, that we can engineer a soft landing, Mark?
Mark: Yeah, I think this is obviously a hope on the part of policymakers, but I don't think it's necessarily the expectation. I think analysis of past cycles will tend to suggest to you that monetary policy cycles don't normally end with a soft landing. They normally end with things starting to break and a bit of a recession occurring. I think the one thing in speaking with the Federal Reserve, they would observe though that, in a way, they can't afford to engineer an outcome where they are pausing on interest rates too early only for inflation to re-emerge and become problematic thereafter.
If they are going to make a policy mistake, they would rather end up taking interest rates a bit too high for a bit too long, because if the economy does slow down and if the unemployment rate does move up, say towards 5% in the US, the central bank is now at a starting point where there is plenty of room to cut rates thereafter in order to stabilise the situation, should that arise. So, I think, from our point of view, I think the baseline assessment here is that, at the end of the cycle, we are likely to see a mild recession.
But again, I'd emphasise there's a lot of uncertainty around that. And I would say that by contrast here in the UK, we're probably more worried about the outlook for growth. We feel that intrinsically the UK economy is underperforming other global economies. At the same time, inflation seems to be a bit higher than it is elsewhere. So, there is a bit of a risk of stagflation in the UK – that is to say a mix of high unemployment coupled with high inflation. And I think that that could be a very challenging backdrop for the UK economy over the course of the next couple of years, which is frankly one of the reasons why, from a strategic point of view, we actually think that the pound may actually be a currency that underperforms some of its peers on a medium-term view.
Chris: And as you rightly point out, the IMF recently downgraded its forecast in the UK ranking us pretty low in that point of view. And in an environment where inflation is more volatile and uncertain, then the risks of that stagflationary environment clearly are higher.
So, moving on to think about the policy path for interest rates over the last sort of six months or so, we have seen interest rates starting to move a little higher in the US, as participants have been pushing out their expectations for rate cuts. Potentially as well, reducing the amount of rate cuts that are potentially likely to see. Now, what do you think has been driving this, JP?
JP: That's a good question, Chris. So, we have seen that inflation, although it has been on the right direction of travel coming down, we're not there yet. So we're not getting close to the central bank targets in the near term. So, central banks have a little bit of comfort that they can wait a little bit longer. We've seen that economic growth has been quite resilient and they get to a point where they feel they are restrictive. And we also have seen that in the rhetoric of the different central banks where they actually indicate that they would prefer to plateau around these levels.
So, keep rates at these levels, but for some time to ensure that inflation continues the decline towards their target. I think what is behind that comfort that they can keep rates here for the time being is that so far in the face of those interest rate increases, the economy has remained rather resilient and, so far, they feel the economy can cope with this.
Chris: And Mark, what are you seeing from here? I mean, it seems to me that the central bank models are very much geared around the last sort of 25 years when potentially the environment was very different. I mean, is this a particularly challenging environment for central bankers to work out what to do next? And is there a risk ultimately that we see higher interest rates from here?
Mark: Yes. I think it is a challenging backdrop for central bankers in general. I think there's a lot of uncertainty around how the economy continues to evolve and behave in this period, which is the post-pandemic period. I would say that a particular uncertainty has been how inflation is behaving and how growth is behaving in response to the move up in interest rates that we've seen thus far.
As JP was saying to this particular point, we've seen interest rates rise by quite a lot in the US, by over 5% over the course of the past 18 months, yet the economy doesn't seem to have slowed down just yet. Now, I think there are particular reasons and factors which explain that. Partly because, in the US, householders are very lucky to have fixed-term mortgages for 10, 20, or 30 years. But it does mean that effectively consumers have been effectively hedged against the move up in interest rates. So, consumers haven't really felt the higher borrow costs in the pocket.
Similarly, when interest rates start to go up, normally what we see is that companies have, at the economic end of an economic cycle, ended up building up a lot of debt, a lot of leverage, there's almost been too much bullishness. But this time around we've actually started a hiking cycle with balance sheets both on the consumer and also on the business side in very strong shape. So, it's taking a long time for policy action to actually have any traction, to have any effect in slowing growth.
But I think the one thing that I would emphasise is, we know how economics works or we like to pretend that we know how economics works and we do believe that the economies are going to slow down in response to tighter policy. It's a question of when, not if. At that question of when the slowing in growth occurs, when we move maybe more towards a recessionary outlook is the question that I think is keeping us all on our toes.
And certainly over the course of 2023, I think a lot of prominent economists have been surprised at how strong the US growth path has continued to be. So, plenty to think about and certainly there's a potential that interest rates still need to go a bit higher still. But, as the Americans would say, we are very much now in the ninth inning of this monetary tightening cycle. I don’t know how long that ninth inning will last for but we do seem to be in the late stages.
I think what there's more uncertainty around is when are we going to see interest rates starting to come down because that will probably be more of the catalyst that you want to turn more bullish on the outlook for bonds. It could also be a moment when more caution on risk assets is warranted elsewhere.
Chris: I think the phrase I often hear is that interest rates work with a long and variable lag. It seems that that lag is becoming, increasing over recent months. So, we've touched on the inflation environment, we've touched on the labour markets, and the resiliency of growth. It's probably worth now thinking a little bit about how all of that comes together when thinking about allocating to high-quality fixed income, so government bonds, for example, within a portfolio at this point in time.
So JP, from your perspective, how have you been seeing government bonds recently? Is now the time that you think it makes sense to be adding from an asset allocation perspective?
JP: Yes. First of all, we'll always keep reminding clients that it's a multi-asset portfolio where you look at the diversification as the main objective to invest for the long term. But within that, we dial up and down holdings for the different asset classes. Here, we recently have been adding to government bonds in some of the portfolios where this is appropriate. We think from here the balance of risk is that we are very close to peak interest rates and that inflation will continue to drift lower, although that will not be a straight path.
And we think that within fixed income, you are rewarded to dial up the exposures a little bit. But we also have seen that the fixed income markets have remained very violent. We've seen the volatility and some of the magnitudes could be being quite astonishing. So, the wobbles in fixed income also present some of the opportunities. So, for example, in some of the funds we have been long Gilts versus Treasuries since June. So, there we did see quite a significant wedge diverging, which also has been reversed and has been recently closed.
So, definitely within fixed income, a lot of interesting things happening and definitely peaking our interest at the moment.
Chris: And Mark, the sense I get from yourself is that your strategies have been a little bit more conservative in taking directional risk when it comes to particularly US fixed income. How have you been seeing things?
Mark: So that's right. I would emphasise that if I cast my mind back a couple of years, we actually saw interest rates at nothing. We even saw European interest rates at less than nothing. We saw bond yields, which were negative. I remember at the time actually effectively giving a sales pitch, standing up saying, “invest in these bonds, I guarantee they'll lose you money. Maybe they'll lose you less money than the bond portfolio from the Portfolio Manager next to me.”
But a couple of years back, it didn't look like fixed income was a very attractive asset class at all. Effectively, the risk-free return, which is government fixed income, had become a return-free risk. And so, thematically, we thought it made sense being really pretty cautious when it came to thinking about holding bonds in portfolios.
But I have to say that with interest rates moving back up, we are now at a point of valuation on a medium- to long-term view where valuations do look attractive. If you speak to most central banks, they'll say that interest rates are now at a level which is above what they think the long-term average interest rate will be. And consequently, if you are taking a longer term view today, you might actually expect yields in the future to be a bit lower than they are currently. If this is the case, you are not only earning what is a relatively attractive yield, but you can also stand to benefit in terms of capital gains should yields fall. As yields fall, bond prices clearly go up.
And so from that point of view, we do think that it's a more interesting moment to be investing in fixed income. If I think about the multi-asset strategies that we are running within our organisation, here we've actually had an underweight towards fixed income and an overweight towards equities. If anything, we've actually just moved that tilt back towards a neutral allocation in equities and a neutral allocation in fixed income. And it could be that the next step for us, thematically speaking, would be to move overweight fixed income.
But I wouldn't say that we are there just yet because, as we mentioned earlier in the podcast, when we look at the US economy just for the time-being, growth hasn't rolled over just yet. For the time-being, the economy continues to look relatively healthy. And so those moves may more be moves that we are looking to make more as we travel towards 2024.
Chris: And some of the things you've mentioned there really make me think of some of the risks out there that we've not covered. And one area that potentially pops up from time to time is Japan and the policy there. Now, clearly Japan has been a bit of an outlier in terms of their policy running very, very loose policy. But they are very big component of the global government bond market and they're also a big investor in international bond markets. You've had a lot of experience in Japan, Mark. How do you see things progressing from here, from Japan's point of view? Do you expect to see more policy change and do they create some risks for the global bond market going forward?
Mark: Yes, so Japan is interesting and certainly somewhere that I've loved visiting – somewhere that is actually become a lot cheaper to visit over the course of the last year or two with the yen going weaker. I think the observation in Japan is that, in a sense, policymakers have been in somewhat of a denial state about the fact that inflation has re-emerged in Japan. Effectively, there's been a 30-year period where no one in Japan has seen any inflation at all. And so prices haven't been moving for over a generation.
But on the back of ultra-stimulative monetary policy and fiscal policy, we've actually seen a core inflation rise to a 4% rate in Japan. And, consequently, we do think that the Japanese monetary authorities are coming under increasing pressure now to start to normalise interest rate policy. If this occurs, we think that Japanese bond yields, which are still close to 0%, are likely to rise. We also think the yen, which I think frankly is a very undervalued currency at the moment, may actually start to appreciate with these shocks occurring – we would say that this is a factor that could risk a further move up in global bond yields.
However, we do think that such a move up – were it to occur – could well represent a buying opportunity. It could be a moment that, if you see yields move higher than they currently are today, if we are looking at 10-year bonds moving to 5% plus, we actually think that this is the time when thematically we would start to feel much more confident about wanting to be long in interest rate duration.
Chris: And while we're talking about risks, are there any other risks out there that are keeping you awake at night? What is it that you worry about?
Mark: Well, I'm not sure how well I'm sleeping these days with everything going on in geopolitics and everywhere else. But, the one thing I would choose to highlight is that, in credit markets, it's interesting that when we think about the last big recession in 2008, it was very much banks at the epicentre of all of the problems we saw in that particular cycle. We actually think that in the cycle coming, actually banks are now very tightly regulated. They don't take a lot of risk. They've got a lot of capital reserves. We think a lot of banks now look very safe, particularly the big sort of European and UK banks. If there's a worry about banks, it's more the US regional banks.
So, we don't think problems if we see a recession will manifest there. And, consequently, we think that bank credit is very attractive to own at the moment. We can buy high-quality paper yielding 7%, 8%, 9% in terms of European financials. But where we are more concerned are some of the weaker parts of the credit market, not necessarily high yield bonds as much as high yielding bank loans, which has been a big growth market over the course of the last several years, which is an area where we see more weaker borrowers showing up.
And we've also seen an erosion in covenant standards in those bank loans. So, we think that bank loans is an area that worries us, as are private markets in general. There's been a lot of money that's gone into private debt and private equity over a number of years, and that's made a lot of sense when there's been not a lot of value in public market fixed income. However, this is a part of the market where the IPA pipeline is very weak. There's no exit for private capital. It's a part of the market where we see relatively high degrees of leverage and we think that defaults are going to be elevated.
So, we think that if you are looking at where are the losses going to come in this particular cycle, it's often where there's been a bit of a gold rush over the course of the few years that have followed. And surprise, surprise, those people who are piling their money into crypto and digital assets – they’ve been losers over the last year or two. But I think the other big area where there's been a big gold rush and maybe too much money has been allocated too quickly, and some investors may come to regret will actually be more in private markets.
In a way, whenever something is too fashionable in financial markets, it's nearly always a smart idea to be going in the opposite direction. And so from that point of view, bonds have been badly out of fashion, haven't they? But maybe it's a bit of a time for a bit of a renaissance – flares are coming back.
Chris: I think that's a really, really interesting point about the private space. And I think the potentially lack of transparency and information of what's going on under the hood probably makes life a little bit more difficult for investors to assess all of the risks that are there. But I think that's a very good point.
Jean Paul, on your side, what are you seeing in terms of the risks? What worries you?
JP: What worries me? So, again, excluding geopolitics as the number one, it is a little bit more high level. So I think one of the things we've seen in the recent episodes is that inflation is incredibly important. So, if we look to a society or if we look to inequality intergenerational, we see that inflation is incredibly important. But what we have seen is that central banks actually got formal inflation targets since the mid-nineties, and that we actually see that there is a lot of importance of trying to get the inflation towards a target.
But what we actually did see around the great financial crisis is that central banks, while inflation expectations are well anchored, so don't worry, then inflation drifted lower and they actually ignored the models and became much more data dependent and came up with all kind of working papers on the issue of having zero interest rates.
Now we see a little bit refers where inflation surges higher. Initially they say transitory and then they throw away the models and say, we become more data dependent. So a little bit of a concern for me is for perhaps all the economics research and all the economists time they spend on trying to explain transmission mechanism and really understand inflation, I think it remains to some extent a bit elusive.
So, the real control on inflation that central banks have is very indirect and very difficult for them to manage, where actually the role of central banks has become hugely important in the last decades.
Chris: That's fascinating. Now before we let you go, Mark, I do want to ask you one last question. I think, one of the key questions often for our investors is whether to think actively or passively in terms of how they invest. Now clearly you are an active investor and you look to add value to portfolios relative to the broad market.
As bond investors typically we're less optimistic. We've gone through a tough period where volatility has been suppressed by central bank behaviour, and that seems to have changed. And the sense I'm getting from you today is that the opportunity set for you and the market that you're now in gives you a much greater sense of optimism when it comes to active management. How are you seeing things there and how optimistic would you say you are now versus the last decade?
Mark: Well, thanks for the question. I think the one thing that I'd say for starters is I feel very lucky to be a fixed income Portfolio Manager because frankly, it's an easier job than being a stock-picker in equities. Maybe don't tell too many people that I've got an easy job, but I would contend that actually fixed income's a very inefficient asset class.
There's a lot of people who own fixed income, not because they're trying to earn a yield or maximise profits. Fixed income gets held for regulatory reasons. It's bought by central banks and none other non-economic participants. So, fixed income markets are inefficient. We see an abundance of new issuance of securities all the time. We have the presence of term premia, volatility premia, credit premia, liquidity premia, and all of this means that if you are a skilled active investor in fixed income, you should be able to beat your benchmarks year in, year out with a degree of repeatability.
That's certainly something that we've sought to build our own franchise upon. And so I would say that in as much as volatility is going up, if anything, it only begets more opportunity as an active investor because we speak about the ability to deliver performance versus benchmark – jargonistically, we call this alpha. But in terms of where this magical mythical alpha comes from, it's really only a function of two things. One is the volatility in your opportunity set, and the second is your skill in order to harvest that volatility.
So, from that perspective, in as much as volatility is going up, is creating more opportunity, it should be a fairly interesting time to be an active fixed income manager because I do think there is an ability to deliver performance as an active manager in the fixed income asset class. So, from that point of view, I'm certainly feeling happy about my job. I don't think it's disappearing because of AI anytime soon.
But also I think thematically and strategically, I'd also acknowledge that as much as we've been able to deliver alpha consistently over the course of the past 10 or 15 years, clearly the asset class in itself has been a tougher sell at a time when yields have been next to nothing. Now that we are actually looking at an asset class where the yield – the income you can achieve – is attractive, I think it's certainly a story. It's easier to get behind. For example, even if you look at US Treasury bonds, the inflation-linked Treasury bonds today will guarantee you 2.5% above US inflation.
So, in a world where you get inflation plus, this is a very different world of valuation compared to a world a few years ago where I remember UK index-linked bonds were actually giving you a negative yield – they would give you inflation minus 2.5%. These were bonds, which if you bought a couple of years ago were guaranteed to lose you half of their money in real terms if you held them to maturity.
So, I think we are in a very profoundly different valuation point today compared to where we were then. And so from that perspective, yeah, I feel pretty happy, pretty bullish about my future as a fixed income manager at the minute.
Chris: Good to hear. And finally, JP, can you just give us a little bit of insight into what's been driving markets lately?
JP: Yes. So, recently we see that inflation data and the labour market data in the US continues to be rather strong. Whereas, in the UK, we see some softening in wages and labour markets. A little bit further, we see that data out of China is tentatively improving. We see that interest rates remain very buoyant and some bonds actually have had a largest drawdown on record.
So, we've seen that the markets remain caught between whether the glass is half full – very resilient economy, labour markets getting to the area of a soft landing versus the glass half empty. Where do rates top and is there any economic harm on the horizon?
Chris: So, that really leads me just to thank you both for your time. I think, if anything, this discussion illustrates how uncertain the future path remains, how complex it is to invest in this environment. And I suppose as always, we continue to think it makes sense for investors to maintain a diversified portfolio that's really designed to weather a range of different outcomes that includes amongst other asset classes, government bonds.
Today's discussion hopefully gives you a small insight into the expertise that goes into building these diversified portfolios that aim to weather those uncertain outcomes. Thank you again for listening and we hope to be back soon.
All investments can fall as well as rise in value and their past performance is not a reliable indicator of future performance. This podcast is not a personal investment recommendation.
