With inflation perhaps a long way off and deflation a far more prescient concern, fixed income managers are going niche.
‘You’ve got to bear in mind, Japan has been able to cope with high levels of government indebtedness for many years and it’s just ticked along at a nice, albeit very, very low, pace of growth. I think this is the direction the rest of the developed world is heading,’ said Ariel Bezalel, head of fixed income strategy, Jupiter Asset Management.
Anyone waiting for inflation to pick up in major global economies anytime soon will be disappointed, experts say.
The impact of the coronavirus pandemic and demographic trends already in motion pre-Covid-19 make it more likely that deflation will be a bigger issue, putting pressure on central banks, which are thought to be running out of steam. As a result, fund managers are having to look further afield – in private markets and niche products – to deliver income to investors.
‘Now that interest rates in all the major global economies are more or less at zero or negative [levels], and central banks have once again been running quantitative easing programmes, which once again seem to be working in terms of inflating asset prices, they appear to be really struggling to hit their inflation targets and the real economy seems to be in a bit of a mess,’ said Ariel Bezalel, head of fixed income strategy at Jupiter Asset Management.
Speaking at a Citywire virtual roundtable, Bezalel pointed out that although there was an extended bull market in the last decade prior to Covid-19, it was still the weakest recovery in post-war history, with major economies missing their inflation targets for most of the period.
With the pandemic hitting hard certain sectors, such as global travel, he believes there will be permanent scarring, putting deflationary pressure on economies.
In addition, Harry Richards, a fund manager at Jupiter, noted that debt, demographics and disruption are three forces that have accelerated as a consequence of the pandemic.
‘If we look across advanced economies over the last 20 years, inflation, across all of them, has probably, averaged around 1.75%. So, on average, they’ve missed their inflation target and during this quarter, this crisis has now fallen to zero, on average, for advanced economies,’ says Richards.
In Bezalel’s view, monetary policy is now tapped out, with ‘the situation quite worrying, because it feels like central banks have run out of road’. They have failed to meet their inflation targets, despite having used most of the tools available to them.
Indeed, the annual US inflation rate was 1.3% in August, down from 2.3% in February, according to the US Bureau of Labor Statistics, while in the EU, the annual inflation rate was 0.8% in July, down from 1.6% in February, according to Eurostat figures.
One tool still at the disposal of central banks is control over the yield curve. According to Abu Dhabi Commercial Bank fund manager Szymon Idzikowski, they can target ‘certain ranges of the yield curve and buy back bonds matching that segment of the curve, to allow governments to potentially issue more bonds to stimulate the growth, but at the same time, help governments put a cap on the cost of those bonds’, as they had previously done in Australia and Japan.
On a cautious note, Kaushik Chaudhury, head of portfolio management at Saudi Fransi Capital, warned that current market dynamics, and the changing function of central banks, will lead to increased conflict between central banks and governments.
‘We already see that happening,’ he said. ‘The traditional role of the central bank is to conduct monetary policy, with the interest rate being the main tool. Nowadays you increasingly see that the central bank is supposed to not only manage monetary policy, but also stimulate growth and moderate business cycles, and so on. I think this conflict is probably going to play out over the next few years.’
Moving away from fixed income
‘The good news is that our portfolios don’t need to be dependent only on the fixed income asset class to find income,’ said Appul Jaisinghani, head of investment funds and structured products at Emirates NBD.
He also does not see inflation rising towards the fed’s 2% target in the near future, particularly given the current Federal Reserve policy stance. ‘The massive deflationary and demand-sapping shock of Covid-19 and the spike in unemployment that it has created are going to leave a lot of slack for a long time,’ he said.
From an income generation perspective, Jaisinghani is also looking at global real estate investment trusts (REITs) in addition to the traditional fixed income. He argued that there are structural tailwinds for growth in a number of sectors within global REITs.
‘For instance, the rise of ecommerce and shifting demographics are creating sustainable demand in the logistics space and quite a few REITs are actively invested here,’ he said. ‘There are other niche areas too, such as cell towers and data centres, which provide a great opportunity to get exposure to the growth of data consumption and centralization of computing power respectively.’
For Chaudhury, who is finding opportunities in select emerging market debt and better-quality high yield names, the decision in fixed income is currently about choosing ‘which one looks the least ugly’.
‘Interestingly enough, because we are based out of the region, we do see some opportunities in Middle Eastern papers,’ he said. ‘Frontier banks, for example, quasi government entities, most of these names would probably offer you a pickup of around 150 to 200 basis points on average.’
Agreeing with Chaudhury, Abu Dhabi Commercial Bank’s Idzikowski said despite being underweight fixed income overall, he still has to present something in this space to clients. But instead of giving up on quality and buying high yield names, he believes private markets can offer an alternative.
‘We’ve seen a lot of growth in that space,’ he said. ‘For the asset class as a whole, you could argue that we’ve seen most of this post-financial crisis growth on the back of regulatory changes, where banks and financial institutions have been asked to increase their capital ratios. They reduced their lending, which basically resulted in the creation of an alternative asset class – private debt – and we think there are a lot of attractive opportunities in that space.’
He is also looking at more niche areas such as CoCos, which were also created on the back of the financial crisis to help banks recapitalise, as well as catastrophe bonds or insurance linked products.
‘Broadly speaking you either have to sacrifice quality or liquidity, or you go for something niche. Perhaps something complex where you get a, let’s call it, complexity premium,’ Idzikowski added.
According to Bezalel, credit selection is key to finding income in a world of policy intervention and negative interest rates. His base case outlook is for the ‘gradual Japanisation of the developed world’.
‘The tail risk is that we do get the move towards some modern monetary theory or something that we need to keep a close eye on, but as things stand, with debt, demographics and disruption, our view is that we will get this gradual Japanisation,’ he said.
‘You’ve got to bear in mind, Japan has been able to cope with high levels of government indebtedness for many years and it’s just ticked along at a nice, albeit very, very low, pace of growth.’
Ariel Bezalel - Head of Strategy, Fixed Income
Harry Richards - Fund Manager, Fixed Income
Szymon Idzikowski - Fund Manager, Abu Dhabi Commericial Bank
Appul Jaisinghani - Head of Investment Funds and Structured Products, Emirates NBD
Kaushik Chaudhury - Head of Portfolio Management, Saudi Fransi Capital
Chairperson, Audrey Raj - Editor, Asia