Pilar Gomez-Bravo was recently appointed Director of European fixed-income for MFS Investment Management. She also serves as Lead Portfolio Manager for MFS Meridian Funds Global Total Return and MFS Meridian Funds Global Opportunistic Bond. Pilar shared her views on the global debt markets during the 2017 MFS European Investment Forum in London.
Beginning with the disparity between what the US Federal Reserve is saying with regards to rate hikes and what the markets are anticipating, the Gomez-Bravo says the markets are probably right. «The Fed has been lowering its neutral rate, which indicates the extent to which they expect to raise rates, dropping now to 2.75%, whereas the 10 year yield is even lower at 2.3%. Every time there has been a difference between market expectations and those of the Fed, it’s the Fed that invariably moves towards the market. The Fed’s rate policy guides the short end of the yield curve and that is where its communication and guidance is focused. What Central Banks would really like is to be able to control the long-term slope of the curve because it determines the level of accommodation of monetary policy.»
Likewise, Pilar Gomez-Bravo doesn’t see rate hikes in Europe in the short term, although she does acknowledge that the European Central Bank will want to avoid any mistakes as it manages the exit of its public asset purchase program. They also want to assure the markets that they are not going to change the deposit rate, which is currently still negative. «At a time when the unemployment rate has fallen, and growth is on the rise, the European Central Bank will begin to consider that it makes sense to stop buying assets and injecting liquidity into the market. Another issue is that the ECB doesn’t have many more options, given the criteria established for the purchase of government assets. The time will come when it can no longer maintain the guidelines that were established in the buying process. The ECB will want to avoid creating panic -similar to what happened during the Taper Tantrum in 2013, which led to widespread selling of risky assets and a drastic rise in interest rates- largely due to poor communication from the Fed.»
At MFS they expect Draghi to continue to gradually reduce the ECB’sdebt balance due to the lack of alternatives. They will also try to create as much distance as possible between the decision to withdraw liquidity from the market and the commencement of the interest rate increases. «It‘s possible that the European economy will continue to strengthen and we could see rate increases well before the end of 2018, which is what is currently priced into the market.»
What is the expected inflation scenario?
It’s expected that there will be very little upward inflationary pressures, mainly due to the market structure. Globally, there is an immense amount of debt, which limits the extent to which rates can be rise without leading to a recession. In addition, there are certain demographic problems in the United States and other developed countries that prevent inflationary pressures on the labor side. «The generation of Baby Boomers who tend to have very high wages is beginning to retire, and the generations replacing them earn much less. Companies are not investing and there is no growth in productivity in the United States, indicating that inflation will be contained. In a world dominated by technology and demographic shifts, conventional wisdom stops working. We’ve seen unemployment fall, without a meaningful increase in inflation, particularly in the United States. In Europe, disruptive technology are not having the same impact that we’ve seen in the United States, where companies like Amazon or Airbnb suppress pricing pressures. That’s why we could see rising inflation in Europe before it takes hold in the United States. In both cases inflationary pressures will probably come from wages and commodity prices, and in particular from oil prices, if we see sustained upward pressures in either of these two variables, we will change our vision on long-term inflation.»
The importance of credit selection
In an idyllic period of low inflation and low growth, the business cycle is much further along in the United States than in Europe. Until now, MFS had had a preference for US companies, because it’s a large deep market, with a lot of diversification and credit capacity. «The United States offers relatively high rates compared to other countries, but the cycle is coming to an end; while in Europe it still has further to go. Eventhough we have to account for European and US credit valuations, we do think that Europe may offer somewhat more value because the technical valuation is supported by the European Central Bank which continues to buy bonds.»
At present, credit selection, of a specific bond or issuer, through analyzing its parameters and fundamentals, that leads to investing in bonds on which there is a high conviction, has much more potential to deliver alpha than directional positions, since the latter have their performance limited to that of a market that is trading at high valuations. «Investing in higher-conviction securities makes sense for two reasons: you can avoid potential losses of some market issuers and concentrate the portfolio in those names where we see greater potential for outperformance. We have also been reducing systemic credit risk in our portfolios, while looking to generate more opportunities by investing in specific credits, which we believe will lead to a longer lasting source of alpha.»
The emerging credit market
In emerging markets, after the 2017 super rally, we see value in certain countries whose fundamentals have significantly improved, such as in Indonesia, India, Brazil and Argentina. We continue to see value in emerging market debt, both in hard currency and in local currency.
Is now the time to add more risk to the portfolios?
The current bull market is approaching nine years. MFS is positioned somewhat defensively because they are expecting a market correction and current risk adjusted valuations are not as attractive. Still, Gomez-Bravo argues that there are still opportunities for investors and that the more flexibility one has the better: «If you manage funds that are more global, or if you have a multitude of factors to choose from, you diversify the portfolio while removing risks. But we are still waiting to see what happens with tax reform and fiscal policy in the US. The market forgets that when liquidity dries up there is no turning back. During the last crisis, many investors weren’t able to sell their short duration floating rate bonds, and they had to settle for 50 cents on the dollar. Taking on a lot more risk for an extra 30 basis points doesn’t make sense in this environment»