CC-BY-SA-2.0, FlickrPhoto: Chris Saulit. Euroclear And Lyxor Asset Management Collaborate To Bring Greater Transparency To Fixed Income Liquidity
Euroclear and Lyxor Asset Management are cooperating in the launch of “e-Data Liquidity,” an innovative tool enabling fixed income market participants a method of accessing the true intrinsic liquidity of an asset, therefore providing the full liquidity profile.
Against the backdrop of increasing regulatory requirements, accurately monitoring the liquidity of an asset plays a key role in helping investors adequately price assets and allocate their funds. Measuring liquidity can prove particularly challenging for fixed income securities, which mainly operate over-the-counter and offer less transparency by nature than other markets.
Stephan Pouyat, Global Head of Funds and Capital Markets at Euroclear said: “The current market climate is prompting investment managers, treasurers, risk managers, insurers, collateral takers, central counterparties and other buy-side institutions to better manage their asset portfolios and strengthen their balance sheets, including liquidity buffers. e-Data is a modular tool and the liquidity module provides key indicators founded on our neutral settlement data and presented in its simplest form, relying on the infrastructure stamp of Euroclear. This first module, designed in close collaboration with Lyxor, focuses on supporting the management of fixed income and more specifically high quality liquid assets.”
Jean Sayegh, Co-Head of Sovereign Bonds Investments, Lyxor Asset Management added: “Lyxor has always helped its clients understand and adjust to a rapidly changing environment. By teaming up with Euroclear we are participating in the current regulatory drive for market transparency and providing fixed income investors with an innovative tool helping them better manage their portfolios. This partnership confirms our expertise as an innovative and growing fixed income asset manager. By leveraging on the depth of Euroclear data, Lyxor creates value for its clients”.
The bond market’s volatility in the first quarter of 2016 had a familiar feel to it, as persistently sluggish global growth prompted renewed efforts by central banks to combat it. The good news is that after the quarter’s gyrations, value in specific credit sectors discussed in our fourth-quarter 2015 report remains intact, despite strong rallies in these sectors after mid-February.
The year started ominously for risk assets, with a large sell-off in equity markets as well as the high-yield bond and floating-rate loan credit sectors. Investors reacted to fears of another global downturn akin to the financial crisis, possibly sparked by a Chinese hard landing and currency devaluation, and a U.S. recession. The S&P 500 gave up 9% between January 4 and February 11, with smaller losses for high-yield bonds and loans.
Central banks responded with a multipronged stimulus package by European Central Bank President Mario Draghi, and moves by Federal Reserve Chair Janet Yellen to scale back the number of rate increases expected this year, citing risks posed by “global economic and financial developments.” China, for its part, denied that it was planning a major currency devaluation and pledged to do more to boost its economy.
Markets bounced back sharply – the S&P 500 regained 12.6%, and high-yield spreads tightened from 887 basis points (bps) to 705 bps – just 10 bps wider than year-end, based on the BofA/Merrill Lynch U.S. High-Yield Master II Index. Exhibit A shows the V-shaped recovery of equities in the second half of the quarter.
Taking measure of interest-rate and credit risks
Despite the rebound, today’s environment poses a unique set of interest-rate and credit risks for fixed-income investors. Profits for S&P 500 companies are expected to fall 9% for the fourth quarter, which would be the fourth consecutive quarterly earnings decline and the first such streak since the financial crisis. Tepid economic growth remains a burden on companies. At the same time, we believe the Fed is still likely to raise its target fed funds rate this year, as it is very close to achieving (and perhaps exceeding) both its unemployment and inflation targets. Though not as urgent as previously thought, fixed-income investors remain vulnerable to rising short-term interest rates.
In this vein, we believe the case for the three sectors we highlighted in our fourth-quarter report – high-yield bonds, floating-rate loans and municipal bonds – remains intact, should short-term rates rise.
In Exhibit B, the dotted square box shows the last period (2004-2007) in which the Fed hiked its target fed funds rate. All three sectors had positive total returns during that period, so it would appear that a likely scenario of modest hikes would pose relatively little threat to returns in these three sectors.
Credit concerns also remain legitimate, given continuing slow economic growth combined with a reasonable likelihood that the U.S. economy is in the latter innings of the current credit cycle. Despite this, however, in our view current valuations and income offered by below-investment- grade debt more than compensate for the credit risks assumed. We also believe active management is particularly important and relevant currently, given deep credit stress in particular sectors, including energy and commodities issuers.
Spreads on both high-yield bonds and floating-rate loans are at levels comparable to 2011, in the aftermath of the financial crisis, and are 143 basis points and 68 basis points higher than the median over the past 10 years, respectively. Of course, spreads could always widen further, but today’s levels represent a “value cushion” that is very rare – slow growth and high expected default rates are already reflected in today’s prices, with discounts below fair value, in our view.
Scatterplots point to high-yield value
For some perspective on today’s pricing of credit, Exhibit C has two scatterplots – the left for high yield, the right for the S&P 500. The dots compare valuation levels for each month since 1988 with subsequent three-year annualized total returns. While the dots aren’t tidy, they make two basic points. In general, the southwest-to-northeast slant of the dots indicates that as the sector gets cheaper (measured by spreads for high yield and earnings yields, or E/P1, for stocks), subsequent three-year returns get higher.
The dots on or very close to the red horizontal lines – indicating the current spread level and earnings yield, respectively – make a specific point about today’s valuations. For high yield, whenever spreads have been at or near the current level of 705 bps (on the BofA/Merrill Lynch U.S. High-Yield Master II Index), subsequent three-year annualized returns have all been strongly positive, ranging from 8% to more than 20%. For the S&P 500, when stocks had earnings yields roughly equivalent to today’s level of 3.8%, the range of outcomes has been much wider – from negative 20% to positive 30%, and about a third of the time the results were negative. At current relative valuation levels, high yield has been the stronger-conviction choice for investors seeking a tighter range of expected return outcomes.
The observation above should not surprise investors. Over the past 10 years, high yield has provided almost the same return as stocks, with two thirds the volatility; over the past 20 years, stock annual returns exceeded high-yield annual returns by 121 basis points, but high yield exhibited just under two thirds the risk and a superior (higher) Sharpe ratio. The high annual income generated by high-yield bonds has been a big factor contributing to these historical risk/return relationships.
Defaults as a lagging indicator
Given that we are in the latter part of the credit cycle, we anticipate that defaults for both high-yield bonds and floating-rate loans are likely to increase from current levels; each are currently near their 10-year medians. However, if investors wait for defaults to peak, we believe they will have missed a value opportunity, because current discounted prices already reflect a significant rise in default rates.
In floating-rate loans, for example, the March 31 Index price of 91.5 means the market is expecting total credit losses of 8.5% over the lives of the loans, which on average has been three years. When you factor in an average 70% default recovery rate that lenders have historically achieved, this implies a three-year annual default rate of 9%, which exceeds the three-year annual rate during the height of the financial crisis. This scenario seems very unlikely to us.
Second, active management can be key in building portfolios of companies that may help mitigate default risk – passive allocations that mirror the Index must include all issuers, including those most at risk. Third, waiting for defaults to improve can reduce potential total return because spread tightening (bond price appreciation) historically has preceded peaks in default rates. Exhibit E shows that in 2009 and 2011, high-yield spreads anticipated the turn in default rates – the tightening started while default rates were still increasing.
Déjà vu going forward
For the bond market, the first quarter of 2016 was déjà vu all over again, which is likely to be the pattern for some time. We believe that staying focused on credit fundamentals and investing for the medium term in active credit strategies is the best approach to seek profit (or protection) from volatile markets.
CC-BY-SA-2.0, FlickrPhoto: Dronepicr. Credit Suisse Closes its Panama Office
Just as it was expected since early 2016, Credit Suisse closes its Panama advisory office. This decision has nothing to do with the Panama Papers, a scandal started with an unprecedented leak of 11.5m files from the database of the world’s fourth biggest offshore law firm, Mossack Fonseca.
Until now, Credit Suisse served the Panama Private Banking clients from their offices at the MMG Tower, in Panama City.
In an email, Drew Beson, Vice President, Corporate Communications at Credit Suisse told Funds Society: “Credit Suisse remains committed to Latin America, a key growth region for our private banking and wealth management businesses supported by our market-leading investment bank. By closing our Panama advisory office, we expect to deliver the same high-quality advisory services to clients out of Switzerland and allow Credit Suisse to strengthen presence on local locations with growth prospects. Other local presences in Latin America are not affected.”.
CC-BY-SA-2.0, FlickrMeraville Retail Park. TH Real Estate’s European Cities Fund Completes First Acquisition
TH Real Estate has acquired Meraville Retail Park in Bologna, Italy, on behalf of its European Cities Fund for a net initial yield of circa 5.96%. This is the first acquisition for the Fund, which was launched on 1 March 2016 as a pan-European open-ended real estate investment vehicle with €200m of equity.
Totalling 35,975 sq m (387,232 sq ft), Meraville Retail Park has been open since 2003 and boasts very strong sales performance, making it one of the top-two performing retail parks in Italy. Featuring a diverse mix of top retail tenants including COOP, Mediaworld, Leroy Merlin and top fashion retailers such as OVS, Pittarello, Alcott and Piazza Italia, the retail park has an occupancy rate of 99.7%.
Liz Sworn, Fund Manager, Europe, TH Real Estate, comments: “Measured against other European cities, Bologna continues to outperform in areas such as employment, growth and GDP per capita. In addition, retail sales growth in the city is predicted to average 1.4% per annum in the next five years, outperforming the Italian average. We strongly believe in the investment fundamentals of Bologna and feel that Meraville Retail Park will prove to be a strong asset for the Fund.”
Located in Bologna, the capital of Emilia Romagna and Italy’s second wealthiest city, Meraville Retail Park benefits from a 30-minute drive time catchment of nearly 800,000 people. In a rating of 1,200 European regions by TH Real Estate’s research team on factors such as employment growth, employment structure, unemployment, population growth and GDP per capita, Bologna rated in the top 12%.
Mario Pellò, Head of Investment, Italy, TH Real Estate, adds: “With its high occupancy rate, strong sales performance and location in Italy’s second wealthiest city, Meraville Retail Park perfectly meets our investment requirements for the European Cities Fund. We believe that the retail warehouse market will be a sector where we will continue to see yield advantage and that Meraville specifically presents strong asset management opportunities.”
The retail park adds to TH Real Estate’s strong presence across Italy, where its current portfolio of 11 assets totals c.€1.3bn AUM.
CC-BY-SA-2.0, FlickrPhoto: Robert S. Donovan. Matthews Asia Renames Fund to Matthews Asia Innovators Fund
Matthews Asia has announced the renaming of the Matthews Asia Science and Technology Fund to the Matthews Asia Innovators Fund.
Managed by Michael J. Oh, CFA, the Matthews Asia Innovators Fund seeks to generate long-term capital appreciation by investing in companies that the investment team believes are innovators in terms of their products, services, processes, business models, management, use of technology or approach to creating, expanding or servicing their markets.
Matthews Asia believes that as Asia’s economy has grown, many sectors such as manufacturing and technology have moved up the value chain in order to improve productivity and enhance their products and service offerings. In addition, Asia is moving beyond its reputation as a region of copycat production, with companies now focused on building market-leading positions through developments that disrupt existing business models.
Underlying these important developments in the region’s economy has been a strong focus on fostering technology, encouraging entrepreneurship and increasing emphasis on creativity. The Fund seeks to identify companies that Matthews Asia believes demonstrate innovation in their businesses and that, over the long term, can generate opportunities for attractive returns for investors.
Michael J. Oh, CFA, Lead Manager: “We believe Asia represents a significant opportunity for investors seeking innovative companies that offer the potential for long-term capital appreciation. The region’s economy is now home to many leading companies within the Internet, e-commerce, software, health care and consumer discretionary sectors. Innovation has been a key driver of success for many of these companies. Since its inception in 1999, the Fund has focused on identifying and investing in businesses such as these, and a broader investment strategy better reflects Asia’s growing, more innovative economy.”
Robert Horrocks, PhD, Chief Investment Officer: “Investing in innovative companies has been central to our investment process for over 20 years. As we celebrate the firm’s 25th anniversary this year, the renaming of the Fund to the Matthews Asia Innovators Fund highlights just how far the region’s economy has progressed during this time. Far from being an economy dominated by export-led companies, we are now seeing innovative companies occupying market-leading positions in sectors as diverse as education, e-commerce and health care. Key to their success has been the ability to deliver products and services that are more closely aligned to the region’s consumers, and I believe over the long term, it is these types of businesses that will make a much greater contribution to the region’s economy.”
CC-BY-SA-2.0, FlickrPhoto: Pictures of Money. Don't Fight Today's Markets With Tomorrow's Money
Given the strength of the dollar — though it has weakened some of late — multinational companies have seen their earnings per share pressured. If you compare the EPS growth rate of US-focused companies with that of their multinationally focused counterparts, there is a very wide gap, points out MFS.
According to the firm, US-focused firms are dramatically outperforming their foreign-focused peers. Revenues, profits and margins are still growing, which is something skeptics would not expect in the seventh year of an economic expansion.
“And perhaps even more important than expanding profit margins are expanding free cash flow margins”, explains in its latest analysis.
“The free cash flow generation of large cap companies, if you strip out energy, materials and industrials, is running near all-time highs. For that reason our outlook for US equities remains strong compared to Japan, where Abenomics does not appear to be working well, and Europe, where labor costs remain persistently high and return on equity is subpar”, write the experts of the firm.
The United States has consistently generated post-dividend free cash flow margins that have exceeded every other region of the world. The composition of the US market — with its emphasis on technology companies and companies that use technology to increase efficiency, its rapid asset turnover and low capital intensity ratio and its use of capital outside the US’s borders as large cap companies globalize — lends itself to robust cash flows that should reward equity investors in 2016, said MFS´ experts.
MFS highlights that in an environment where it exists the possibility of somewhat looser global financial conditions for the foreseeable future, the asset manager is generally more constructive toward higher-risk assets. Equities and high yield debt should be a focus for investors looking to re-risk portfolios, and strong fundamental, bottom-up analysis is critical to that re-risking process.
“Free cash flow generation, which is not a Fed-driven phenomenon, remains the key, and we see that most clearly in US markets”, concludes MFS.
CC-BY-SA-2.0, FlickrNish Popat, co-lead Portfolio Manager, Emerging Markets Corporate Debt team, Neuberger Berman.. "In EM Corporate Debt, We Continue to See Opportunities across Various Sectors Especially in LatAm"
Nish Popat, co-lead Portfolio Manager, Emerging Markets Corporate Debt team, at Neuberger Berman, explains in this interview with Funds Society why is a good moment to invest in emerging debt and why he is looking at opportunities in corporate debt in Latin America, as well as in Government debt in countries like like Azerbaijan, Ecuador, Hungary, Ivory Coast and Indonesia. In currencies, they currently have a long bias with overweight positions in the Indian rupee, Turkish lira and some Latin-American currencies, such as the Mexican, Chilean and Colombian peso.
Emerging markets have been almost reviled by investors in recent years. Is this situation changing, especially in the debt market?
Many investors have, over the past couple of years, been under-allocating their exposure to EM funds as several concerns about China/Brazil/ global slowdown/ commodities and oil & gas and the FED raising rates have all contributed to concerns about Emerging Markets, especially currencies. Over the past two months, as many of these factors have stabilised, we have begun to see strong inflows into Emerging Market Debt, mostly in hard currency but also positive flows in local currency.
What kind of investor is beginning to reinvest in emerging markets?
In the past few years most of the outflows from the asset class seemed to be coming from retail investors. This year, however, we are seeing inflows into EMD from both institutional and retail investors.
Are we currently seeing a good entry point at present?
Pressures on EMD fundamentals are starting to ease amidst a stabilisation in commodity prices and supportive monetary policies globally, while the sharp EM FX depreciation has resulted in current account adjustments in several EM countries. Sufficient FX reserves and low external debt levels continue to support Sovereign structural fundamentals, while elevated spread levels are now more than adequate to compensate for cyclical risks. Finally we see supportive technical at present as well, as investor demand is returning from generally underweight positions, while supply of new issues is relatively light. We believe that overall these factors justify an allocation to the asset class and we have increased risk across our blended EMD portfolios this year as we believe that those positive developments counterbalance the fundamental challenges that some EM countries are still facing.
How will EMD be affected by any Fed rate hikes? What do you expect from Janet Yellen?
The market was certainly impacted when the initial fears of a Fed hike emerged in 2013. Since then, we have seen how cautious the Fed has been in managing the markets fears to the speed and extent of that rise, that when it occurred the market virtually discounted the whole event and so it had virtually no impact on the EM asset class. We continue to believe that the Fed will be very cautious in their approach and at present see the impact on the EMD asset class as having been already priced in.
Is this a reason to favour short durations? What are the advantages of shorter duration in the portfolio?
The main advantage of a short duration approach is the more conservative risk profile with lower volatility and drawdowns, coupled with protection in case interest rates surge at some point. While we believe that this approach can be attractive for investors who are looking for a more conservative, absolute return approach to EMD, we acknowledge that such a strategy typically doesn’t fully capture the upside that the longer duration strategy offers in a rallying market.
Are you now taking increased credit risk or it is not necessary?
We have, over the past few weeks increased our overall risk appetite in the EM universe as we continue to believe that many investors remain under-weight and the stability of the various concerns suggests that the premiums offered by EM issuers were too high in light of the falling risk. We continue to be positive and expect the momentum to continue as the message from developed market central banks remains supportive to risk assets.
Is it possible to find quality investments (IG) in public and corporate debt in EM with good profitability?
Many IG companies in the EM world have continued to make profits, however these are lower than they were in the past as the slowdown in their economies or sectors has an overall impact on their bottom line. We have seen many companies actively manage the situation and expect that while profitability will be lower than 2015, many companies are dealing with the changing global environment better than many investors had anticipated.
What countries (government bonds) and sectors and enterprises (private debt) do you favour?
In EM corporate debt, we continue to see opportunities across various sectors especially in LatAm where many issuers suffered dramatically in 2015 as valuations reached levels which we believe were excessive even though many corporates are going through a difficult period at present. Going forward, we continue to believe that demand for yield will be key in investors’ minds as the Fed and the ECB continue to provide dovish comments and we believe that the momentum for EM corporates remains strong.
In sovereign (government) debt we like Azerbaijan and Ecuador which we think sold off excessively on the oil price move, and we like countries that have been and continue to be on an improving credit quality path which we currently see in Hungary, Ivory Coast and Indonesia.
Is now a good time to take on currency risk or not?
We have become more constructive on EM FX exposure based on improving export growth and current accounts, while valuations and technicals are supportive as well. We currently have a long bias with overweight positions in the Indian rupee, Turkish lira and some Latin-American currencies, such as the Mexican, Chilean and Colombian peso.
Volatility has been strong in recent months, also due to the Chinese theme and commodities. Will this persist? Does that present a need for caution or a chance to seize the opportunity?
The “fear” factor at the end of 2015/ beginning of 2016 has certainly been one of the key reasons why many investors were nervous about investing in the EM asset class over the past year, combined with the increase in volatility as many countries were being downgraded and the China slowdown was certainly a major factor. Over the last 3 months, we have seen how this fear has, for now, diminished dramatically and returns in the asset class have been very strong. Certainly in the short term we see the positive momentum continuing, however the EM world is made up of many countries and companies and accordingly, while there may be issues in one region, the diversity of the asset class enables another part of the world to benefit and accordingly we have seen how resilient the asset class has been over the past years in light of the various issues that have arisen. It is important that investors look at EM on a longer term horizon and while in the short term there may be some headline risks, if we look at the asset class over the past 10 years, we have seen it return a very solid positive annualised return.
CC-BY-SA-2.0, FlickrPhoto: Dennis Jarvis. Are Dividends from Emerging Markets Worth The Risk?
The latest Henderson Global Dividend Index (HGDI) report – a long-term study into global dividend trends based in US dollars– shows how dividends from Emerging Markets (EM) have declined in headline terms* during the last two years, in stark contrast to their significant growth between 2009 and 2013. The trend supports the view that taking a global approach to equity income, with the flexibility to access growth opportunities and seek out attractive yields, is important to help reduce an investor’s reliance on any one region or sector.
*Headline dividends reflect the total sum of payouts received within the HGDI in US dollar terms. Underlying dividends are adjusted for special dividends, changes in currencies, timing effects and index changes.
Dividends from the EM more than doubled in headline terms between 2009 and 2013 (+114.4%), which compares favourably to the 45.1% rise in dividends globally. Since the start of 2014, however, payouts from companies listed in the EM have fallen at a headline level by 17.9%, while global dividends have risen by 8.8%.
A heavy weighting of commodity companies, which have suffered from weak demand leading to many implementing dividend cuts, along with falling emerging market currencies are mainly responsible for the EM dividend decline since 2014. China is the largest EM dividend payer, making up more than a quarter of the HGDI EM total (27%), as shown in the chart below.
Dividends from Chinese companies have almost tripled since 2009 at a headline level, far outperforming the EM and global average. But growth stalled in mid-2014 and since then Chinese dividends have fallen in headline terms for the first time since the HGDI was introduced in 2009. A limited number of commodity companies, however, and a managed currency mean Chinese dividends have declined less than those from other EM countries.
Over the long term, exchange rate effects broadly even out but the impact in 2015 was exceptional and reflected the US dollar’s strength. Last year headline dividends from EM declined by 8.3% but underlying growth was strong at 12.7% (year-on-year). Exchange rate effects accounted for 18% of the difference, with the impact greatest in Russia and Brazil, while the remaining 3% was down to special dividends and index changes.
Henderson Global Equity Income strategy
The geographical allocation of the Henderson Global Equity Income strategy is a function of where the managers find attractive stocks with good fundamentals and appealing valuations rather than being based on an overarching macro view.
Currently, we are finding the most attractive stock opportunities for both capital and income growth in developed markets. The outlook for earnings and dividends remains uncertain in many EM markets whereas most developed markets offer the potential for dividend growth.
While the strategy has a low direct weighting to EM, exposure is also achieved through certain developed market companies with significant emerging market business streams.
Ben Lofthouse became a fund manager at Henderson in 2008 and since then has managed a range of Equity Income mandates.
CC-BY-SA-2.0, FlickrPhoto: Kath Cates. Columbia Threadneedle Investments Appoints Kath Cates as Non-Executive Director
Columbia Threadneedle Investments announces the appointment of Kath Cates to the Board of Threadneedle Asset Management Holdings Sarl (effective 10 May) and the Board of Threadneedle Investment Services Limited (effective 29 March), as a Non- Executive Director.
Ms Cates is also a Non-Executive Director of RSA Insurance Group Plc, where she Chairs the Board Risk Committee and is a member of the Group Audit Committee and the Remuneration Committee. In addition, she is a Non-Executive Director of Brewin Dolphin, where she chairs the Board Risk Committee and is a member of the Group Audit Committee.
Ms Cates’ most recent executive role was Global Chief Operating Officer for Standard Chartered Bank, a position based in Singapore which she held until 2013. In this role she led the Risk, IT, Operations, Legal and Compliance, Human Resources, Strategy, Corporate Affairs, Brand and Marketing functions across 60 countries. Prior to joining Standard Chartered Bank, Ms Cates spent over 20 years at UBS, most recently in the Zurich-based role of Global Head of Compliance. For the previous 10 years she was based in Hong Kong, as APAC General Counsel and then as Regional Operating Officer.
Ms Cates earned a First Class Honours degree in Jurisprudence from Oxford University and qualified as a Solicitor in England & Wales before specialising in financial services.
Tim Gillbanks, Interim Regional Head, EMEA at Columbia Threadneedle Investments said: “I’m pleased to welcome Kath to Columbia Threadneedle. She brings valuable financial services experience particularly in the areas of risk management, governance and regulation and operational excellence. We look forward to working with Kath and to the benefit of her contribution to our business.”
CC-BY-SA-2.0, FlickrPhoto: GIO IAB. Why Are Markets in Denial About Inflation?
As the US labor market continues to improve, investors are still waiting for signs that inflation will pick up. And with US consumer prices posting only a slight uptick in March, the Federal Reserve continues to assure markets that it will “proceed cautiously” in normalizing its policy rate.
Amit Agrawal, senior portfolio manager of developed markets investment grade credit at PineBridge Investments, discusses what’s going on with the Fed’s hawk-dove game and how investors can position portfolios for rising inflation.
Inflation has been benign for years in the US. Why are markets suddenly talking about it again?
Inflation has become a hot topic over the past two to three months because core inflation – which excludes the volatile food and energy components – has risen over 2% for the first time in four years. What many people haven’t noticed is that core inflation has been brewing for a while; 14 months ago it was at 1.6%. If you strip out goods, inflation has been trending over 3% over the past few months.
Why has the core trend flown under the radar?
Because low oil prices have dragged down the headline inflation rate, presenting a mixed picture.
The interesting thing is that despite these moves, the market is still sanguine about inflation. Investors are not convinced that it’s real, and neither is the Federal Reserve. In fact, the Fed is forecasting lower inflation for 2016 than we’re seeing right now. But if you look at past 50 years, US inflation has averaged around 4%; with core inflation at 2% currently, the risk of rising inflation is certainly there. For now, oil has stabilized, the Fed’s messaging is more dovish, and the dollar is trending sideways. These are all positive tailwinds for inflation in the near term.
Why are so many market participants unconvinced? And when do you think they’ll embrace the rising inflation trend?
The reason has to do with wages. The labor market has been improving for five or six years, while wages have been stuck around 2% over that time. Only over the past six months have we seen wages tick up around 2%-3% year over year. In past recoveries, wages have risen 3%-4%. Historically, when labor market slack disappears, inflation tends to show up in higher wages.
As far as when investors will come around, right now, we’re in what I call a “show-me” market. Inflation will have to run higher to convince people it has really arrived.
Several disinflationary trends have made people complacent about inflation: technological advances, demographics, the end of the commodity “supercycle,” and the China slowdown. These do seem like fair reasons for markets to expect inflation to remain low for a long time. (Although I’d argue that demographics may actually be inflationary as baby boomers enter retirement and require more in terms of health care and other services.) In fact, a recent survey by OppenheimerFunds found that, among the top 10 concerns among institutional investors for the next decade, inflation is nowhere to be found.
Unemployment is at 4.9% right now. As slack reduces further, wages will pick up on a broad-based measure. Indeed, the Fed recently reported an increase in wages in nearly all regions of the country in the “beige book,” its survey of economic conditions.
How does the US dollar fit in?
Fed research has shown some impact of the dollar on core inflation, but not a significant one. It’s more about sentiment; inflation expectations can be self-fulfilling.
The impact of the dollar is stronger on headline inflation through oil prices and lower import prices from China. This is why the Fed has been more dovish in recent commentary; the Fed is undermining the dollar because it doesn’t want the dollar to strengthen. (This “ultra-gradualism” is one of the Fed’s unspoken objectives.) By doing that, the Fed will have more conviction in its inflation and growth outlook – growth because of healthy exports, and inflation because it will help keep oil prices from deteriorating further.
We expect core inflation to remain in the 2%-2.5% range over the next couple of years. I don’t expect to see a major pickup, but if wage inflation continues to rise, we expect core inflation could grow as high as 3% over that period.
The important thing is that the market is pricing in an average of 1% core inflation over the next five years. That’s a low bar, and it means inflation assets are very attractive; mispricing means opportunity.
Can you describe the opportunity set in inflation assets?
The opportunity set runs the gamut: Treasury Inflation-Protected Securities (TIPS), overseas markets, European inflation-linked bonds, commodity bonds, gold, real estate, and real estate investment trusts (REITs).
In the US, 30-year Treasury bond yields are about 2.5%, while 30-year TIPS are trading around 0.8%. TIPS are a much better investment than nominal Treasuries from a risk/reward perspective. The 30-year TIPS breakeven rate, which is the inflation component in the TIPS market, currently is below 1.8%. In the last 17 years, we have seen only four instances where TIPS traded below 1.8%.
The opportunity is even more robust in Europe, where the market is pricing in only 0.5% inflation over the next five years – much lower than in the US. Europe is in the midst of a huge push from the European Central Bank to create inflation through quantitative easing (QE). We think they will be successful in raising inflation much more than in the US. The market is way too pessimistic in Europe.
An indirect way to get exposure to the inflation opportunity is commodity bonds associated with energy and metals and mining companies. Many investors are shying away from these due to the broad slide in commodities prices. What they may not realize is that a lot of bonds from strong companies are trading at yields between 5% and 9%. These are companies we believe will survive the industry downturn. So while many investors have given up on commodities because of high volatility, we think select commodities bonds offer lower volatility with attractive upside.
Gold is a particularly interesting investment because it’s not only a commodity but a currency. With the Fed and the G3 undermining their currencies, many investors are turning to gold because it’s the only currency that governments don’t control. Gold was the best performing asset class in first quarter of this year; we expect prices from here will be range-bound, possibly moving up if we see a stronger rise in inflation or if central banks continue to undermine their currencies.
Real estate is another way to gain exposure to inflation. We think there is still some value left in REITs if you believe the US housing market will continue to recover. A big component of inflation in the US is shelter, which includes buying and renting. Home prices are growing at an annual rate of 3%-3.5%, and we expect this momentum to continue. The US has also seen a shift toward more renting, especially in metro areas, with an annual growth rate of 3%-5%.
Finally, investors can also buy direct exposure to real estate, though it’s important to realize that, unlike the other opportunities I’ve discussed, real estate is an illiquid investment.
How do you recommend investors position their portfolios for rising inflation?
If you expect inflation to rear its ugly head in the next couple years, and you own a high-quality portfolio with nominal Treasury bonds, you may want to consider selling those Treasuries in exchange for TIPS. Reallocating this way would allow you to gain exposure to inflation while maintaining the same credit quality.
We think gold is a good asset to own as part of a larger portfolio, not only for inflation down the road but as a safe haven as global central banks cut rates to negative. Equities and REITs are also good hedges against rising inflation.
Overall, you don’t need to make wholesale changes to your portfolios; we would recommend allocating about 10%-15% of a portfolio to instruments that are linked directly or indirectly to inflation.
This information is for educational purposes only and is not intended to serve as investment advice. This is not an offer to sell or solicitation of an offer to purchase any investment product or security. Any opinions provided should not be relied upon for investment decisions. Any opinions, projections, forecasts and forward-looking statements are speculative in nature; valid only as of the date hereof and are subject to change. PineBridge Investments is not soliciting or recommending any action based on this information.
