Navigating Shifting Risk Sentiment In A Low-Growth Environment
Andrew A. Johnson, Head of Global Investment Grade Fixed Income The global fixed income market is increasingly complex and erratic. We live in an overly indebted, overly obligated world, with a growth rate that is slower than we are used to. Central bank activism, very low or negative rates, the threat (even if remote) of deflation and increased regulation have contributed to violent market responses – exacerbated by yield-seeking investors who have been forced out on the risk spectrum and away from their natural habitat. Andrew Johnson shared factors he and his team are focused on in this unique market environment, as well as their potential investment implications. What do you make of the pace of growth, and its effect on investment opportunities? On balance, we believe the most likely economic scenario is one of positive albeit lower-than-pre-crisis growth in the U.S., and more of a struggle for growth in Europe and Japan. We expect significant continued help from central banks. The ECB remains extremely accommodative, as we recently witnessed in the latest round of easing. Japan also is maintaining a very aggressive easing stance, deciding a few months ago to join the world of negative policy rates. And, the Fed still is accommodative, just moving toward “less so.” In aggregate, global growth is low, but still positive. This is not the world of 10 years ago, however, when U.S. growth was running over 3%, helped by the excessive use of leverage. Today, growth is simply lower. Economists generally put potential growth (the rate the economy can grow without stimulating inflation) at 1.5%-2.0%, while the Federal Reserve is expecting slightly above 2%. Europe’s growth potential is probably about 1% and Japan’s is 0%-0.5%. The contrast with pre-financial crisis expectations is a key reason for market volatility – but I think investors should “get real.” A more moderate pace close to 2% is more likely the case going forward. Given this reality, incremental sources of yield become an important portfolio contributor, especially over the long run. We believe there are a number of areas that provide opportunities to capture such yield, including credit, non-agency mortgages, senior floating rate loans and select emerging markets bonds. On the other hand, low yielding government bonds in countries such as Germany and Japan are less appealing. In the U.S., given the level and trajectory of yields, there is little compensation from government bonds currently for the possibility of better economic conditions that could lead to a quicker pace of rate increases. There’s a lot of talk about deflation these days. How likely is it? Deflation is a fear, but a remote one. The problem is that deflation could be highly damaging for the markets, especially those that are overly indebted. A move into deflation potentially sets up the kind of spiral that economist Irving Fisher talked about in the Great Depression of the 1930s. That’s why central banks, from the Fed to the ECB to the Bank of Japan, are doing everything in their power to make certain it doesn’t happen. I believe there are strong arguments against the likelihood of deflation. Although there is considerable debt outstanding, it has been trimmed since the financial crisis, and the debt that has been issued has been well dispersed across the financial system. Moreover, the amount of leverage in the system is down, so there is less risk that asset declines will force sales, and then trigger further asset declines, and sales, and so on. Core inflation has been strong, but somewhat veiled by the sharp decline in energy prices – which we believe is transitory. Then why is the threat of deflation having so much of an impact on markets? Are investors overly worried? However remote the possibility of deflation, the implications are so feared that markets are responding aggressively to the possibility. In our investment approach, we consider various potential economic scenarios or states, in what we call States-Space Analysis. Within this framework, we believe the most likely state is one of low, but positive and stable inflation. In contrast, we assign a state of sustained deflation as a low probability, given the strength of the U.S. economy, the commitment of central banks, and generally constructive financial conditions. Not all investors see it that way. Recent asset price declines due to a sharp fall in energy prices have helped frame investors’ expectations, so relative to the probability of deflation, we believe inflation is underpriced in the market. All this comes with a caveat: Other developed regions may be more vulnerable to deflation than the U.S., given their lower inflation rates, slower growth and the general trend of increased indebtedness. To some degree, Japan is a special case given its long-term bout with deflation and demographic challenges. Europe bears close watching as it seeks to move past recent weakness. Banks securities have recently been in the headlines. What are the concerns, and what’s your take? Credit issued by financial companies suffered earlier this year, in line with equities. Earning concerns arose due to expectations of reduced net interest margins if the Fed departed from its current rate hike path, and revenue reductions from an unfavorable trading and investment banking environment. Loan losses were also a concern given deterioration in commodity prices. The specter of systematic contagion captured the markets’ attention, as Deutsche Bank, after a full year of losses, was feared to delay payment of one of its hybrid loss-absorbing instruments. While some of these factors may impact profitability, credit fundamentals of financials, especially in the U.S. remain strong. Banks are well capitalized with quality assets, liquidity has improved and regulators have curtailed risky activity. European banks are also better capitalized, although many (for example in Italy) have yet to deal with loan vulnerabilities. With that in mind, we favor senior and subordinated debt of large U.S. banks, with more muted enthusiasm for subordinated debt of banks outside the U.S. Names matter though, and we believe that diligence as to issuer and part of the capital structure remains crucial. Of all the economic factors you’re considering, what are you most focused on right now? We are watching consumer behavior, and think it is a major factor in the future economic path. Confidence, retail sales, personal consumption expenditures (PCE), income expectations, the savings rate and credit growth are all indicators we are watching closely. Confidence is fairly high – higher than it was in the middle of the last decade. The confidence of the middle third (by income) of the U.S. population recently hit its highest level since the mid-2000s. So, outside of Wall Street, people are pretty confident; they have de-levered and believe that their incomes are going to go up. However, if confidence rolls over, we have a real problem, because the other contributors to economic activity are not growing enough. In fact, capital expenditures and inventory replenishments are probably going to worsen. Confidence of Middle Third of U.S. Population Near Highest Level Since Mid-2000s Source: Bloomberg. Represents middle third of consumers by income. Fortunately, the energy “tax cut” likely provides a floor for consumer conditions. The wage pie (the number of hours worked times earnings) has been expanding, and as long as that happens, the consumer will probably be fairly optimistic. The savings rate is high – higher than most economists expected – and trending upward somewhat. You would think that, given the repair of the consumer balance sheet, they would “let go” a bit, but that has not been the case yet. Where does all this leave you from an investment perspective? Given the improvement in the U.S. economy and the low probability of deflation, coupled with such low yields, we see limited benefit to holding Treasuries. This is especially true at the short end of the curve, where even though the Fed talks about moving rates higher, the markets still are not convinced. However, we see real opportunity in credit and particularly in the high yield market, where spreads recently widened to a level of historical opportunity. We also believe it makes sense to be somewhat short on duration, given the probability of further, staggered U.S. rate increases. And, we prefer TIPS (Treasury Inflation Protected Securities) to Treasuries given the low inflation expectations priced into the TIPS market today. This is an environment of intensified risk. How can investors account for that in portfolios? Because of low potential growth around the globe, I believe that shocks have become much more dangerous to economies and markets. There is far less of a buffer, as growth and inflation are a lot closer to zero, and the risk of a GDP slipping for a quarter or so below zero is more likely given the low initial rate of growth. Investor psychology also creates market hazards. As investors seek yield and move further along the risk spectrum, they go to places that are less comfortable for them; they’re not in their usual habitat. So, they are more likely to overreact at the first hint of volatility. We saw this in emerging markets, the oil and gas industry, and more recently across the credit markets. Coupled with significantly less liquidity, these jittery investors can trigger sharp market responses, and we believe should be considered when sizing positions, assessing liquidity, and in choosing securities that have a better chance of withstanding short-term volatility. Because we live in a less forgiving economic environment, with jumpier investors, I believe riskier assets should have a higher risk premium attached to them today. This means that spreads on riskier assets may not get to historical levels, and investors could be compensated in portfolios for the higher expected risk. With significant bouts of heightened correlation of riskier assets, it is important to pick through the securities to see where price declines have been warranted, and where securities have just been swept up in the tide of sentiment. 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