Addressing Uncertainty: The Optimistic Zone

Hard landing, soft landing - or even no landing at all? What do these possible economic scenarios mean for bond investors?  Fixed Income Explained Host Peter Marsland returns to tackle these conundrums in the latest episode of our regular podcast. 

Listen in as Peter chats with fixed income colleagues Max Macmillan, George Westervelt and Kathy Collins about their views on likely economic outcomes and their thoughts on asset allocation. 

Are bond investors in the optimistic zone? Find out now. 

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If you would like to listen to the previous episode of Fixed Income Explained Podcast click here.

Transcript

Fixed Income Explained_Sept23

Peter Marsland: Welcome to the second episode of abrdn's Fixed Income Explained podcast. I'm your host, Peter Marsland, Fixed Income Investment Specialist at abrdn, and today we'll be addressing the likelihood of a hard or soft landing, or even no landing for developed market economies, and what this potentially means in fixed income markets across the globe. Joining me today are three of abrdn's finest investment minds: Max MacMillan, Senior Investment Director leading Macro Asset Allocation; George Westervelt, Head of Global High Yield; and Kathy Collins, Investment Director in Emerging Market Debt. So, I've called upon expertise that spans the fixed income investment universe to help tackle this conundrum. Welcome, everyone, and thank you for joining me today. So, let's begin with a top-down view, and I'll start with you, Max, if I may? There seems to be data that supports and also undermines the case for all three of the potential landing scenarios. With this uncertainty in mind, how can we understand the risk on market dynamics we've experienced since late last year? And where are we today? 

Max MacMillan: Thanks, Peter, it's a pleasure to be with you this afternoon. It'd be good to take a step back to begin and notice that, in all the cycles really we've experienced over the past five decades, you tend to get a period late in the cycle of optimism, where even as earnings start to plateau, you have a very strong rerating of valuation multiples, risk assets perform very strongly, and, indeed, the prevalent narrative in those periods tends to be for a soft landing to occur. Now, what's been unusual about this episode, and the strong rally we've seen over the past 12 months, is that it has occurred simultaneously with the developed markets, central banks still increasing rates. And I think there's several reasons for that, that we can lay out. The first one is that inflation, which was the main concern, peaked, core inflation in the US peaked in October last year, and really to see it come back down has provided a lot of relief to markets. Indeed, we know that historically, periods where inflation is falling from a level above the central bank mandates down towards their chosen level, you tend to see a bull market across assets. The second one is we think that the economy has been supported by idiosyncratic factors, such as the strong pickup in fiscal stimulus in the US that we've had this year, but also the pent-up savings, which still exists following the very generous fiscal largess during the pandemic. So, these three factors, we think, have generated this environment - extremely pro risk, where especially this year, even as real rates have continued to rise in the US, up to 2% at the 10 year level, which is the cyclical highs and higher than we've seen, in quite some time now, we've been an environment where risk assets have been able to perform a lot stronger than what anyone imagined 12 months ago.

Peter: And turning to you, George, to take a more granular perspective, what scenario are US market valuations currently reflecting?

George Westervelt: Thanks, Peter, I appreciate it. Thanks for having me. I think it's really an interesting time to be an investor, you know, markets have continued to be very macro driven, as they've been over recent years, and investors search for clues about the direction of the economy and where we're headed going forward. You know, the way we think about it, if we step back for a second, is we have these, I like to think about these two walls of worry and a window of optimism in between. And, you know, that first wall of worry that we saw was clearly inflation. Inflation went from, is it transitory to when will it stop rising? And, and then it was stubborn on the way down to but now we've started to see quite a decline in inflation. But that puts us past that wall of worry on inflation, which is really last year's story and duration linked assets were negatively impacted by that. And now we're in this window of optimism where inflation is coming down, growth is good enough, and you have this kind of latching on to this soft-landing narrative that's pervasive across markets right now. Unfortunately, that window won't stay open forever and we do think that that next wall of worry, which we're likely to see over coming months, is going to be focused around growth. And that's where the likelihood of a recession, starting to see corporate earnings come down, and perhaps the Fed even cutting to kind of save the economy at that point, you know, that plays out negatively for some of the risk-based assets. But that doesn't mean that there's not good opportunities right now. And we can talk about those as we go forward. You know, I guess if we just look at the present, so equity valuations have had a huge run this year. They've rerated higher led by a concentrated group of top performers that we're all aware of, you know, the S&P 500 is up about 16% year to date. So, these are very strong returns and that's despite earnings contraction. So, it's ratings. As equities, rerate higher, I think we're at 20-year highs, if you normalise for the pandemic, as far as PEs. And then if we look at, you know the market that we operate in, which is high yield, corporate credit spreads are trading well inside their historical averages. We acknowledge that, it's hard to say that the market is cheap right now. And really, that's been led by the lowest quality issuers. So, triple Cs are up 14% year to date, with triple Cs being the lowest quality issuers. Within high-yield, includes all the distressed companies, and that 14% is impressive, not only in absolute terms, but also relative to the overall return in the market - US high yield is up 7% year to date. So, you can see that the triple Cs have really outperformed the overall market. Why is that? Again, the soft-landing narrative is taking hold and, as we came into this year, if you recall, most investors including ourselves were positioned pretty conservatively. And throughout the year, investors have kind of scrambled to get back on sides, buying triple Cs to get their risk up. Not a ton of liquidity in those names. So, you know, any kind of move can really show up. And that's what we've seen this year. I guess you know where we stand, we think it's a bit of a dangerous game to be lending to these companies at this point. There's two things that have benefited corporates over recent years that really stand out and one is locking in historically low coupon rates. You know, if we go back to 2020/2021, you had high-yield companies locking in coupon rates of 3%. I can recall a couple two handle coupons for high-yield companies - this is unheard of; you typically don't see this. When you lock in that rate it's typically five to seven years, so that does pay benefit going forward as companies lock in those low coupons. The second thing that companies have benefited from is actually inflation, funny enough. So, inflation provided a lot of corporates an excuse to pass their pricing, and not only pass their pricing but expand profit margins. And we saw that, especially in these lower quality names, you know, the benefit of low fixed interest cost plus expanding profit margins really benefited a lot of these names and you can say, even some of these neighbours that shouldn't have necessarily benefited, were able to kick the can down the road. Right now, what we're seeing, to put that in context, investment grade names - so these are the highest quality names - are coming to the market and triple Bs are printing six to six and a half percent coupons. That's double what the high-yield companies were printing in 2020/21. So, that has a lasting impact. And, you know, as maturities come due over the next couple of years, we'll see that previous tailwinds turn into headwinds for the asset class. And that will be especially pronounced in the lowest quality issuers.

Peter: Wow. So, you've got the wall of worry, which is sort of growth related, but also a maturity wall to contend with as well?

George: Yeah, that's right. So, that ends up being what compounds that growth worry is that, as you roll out into, I mean, really, it's ‘25 and ‘26 for the bond market, ’24 more for the loan market, but as this recession gets pushed out, or everything gets pushed further to the right, you start to run into a bit more problems. So, and one of those is exactly what you're talking about, which would be upcoming maturities, if you have to refinance at a high rate into that, then become counterproductive. 

Peter: Okay, thanks. Sounds like there's a lot to consider in the high-yield and investment-grade credit world. So, let's bring in Kathy now to add some more breadth and to provide the view for emerging markets. So, how does the hard or soft narrative resonate in emerging markets, especially as growth in China appears to be lower than many anticipated?

Kathy Collins: Yeah, thanks, Peter. I guess there's almost two questions there. I mean, hard or soft landing, and then, you know, moving on to China. And I guess, you know, looking back to what Max was saying earlier, it is a bit of a conundrum right now in terms of where we see valuations in emerging markets in the context of these, you know, sort of uncertainties in the market. But yet, as Max pointed out, it is so important to have the context of what we've been through in the last few years. You know, not ignoring things like, you know, the Black Swan event, like COVID, like the war in Ukraine, those things have been very difficult things to contend with in the market. And for issuers too. And I guess the impact we've seen this year in emerging markets is just a lack of issuance, a lack of activity from issuers, as they recalibrate and they get used to the new world, where rates are structurally higher. And it's fair enough that they're sort of taking time to process that and work out, you know, what their next moves are. What is different, I guess, compared to credit, George's market and compared to US high-yield, emerging market issuers do have alternative options. They have local markets, not in every country by far, but there are quite deep local markets in a lot of countries - Brazil, Colombia, you know, Latin America, in general and in Asia. And there are alternative financing plans. Issuers can look to other alternative financing arrangements and we have seen that this year. So, this is the lowest year of issuance we've had in the last 10 years. That's definitely related to the question of hard or soft landing. We've seen activity pick up as you know, markets certainly pushed that that question into 2024, you know, at the beginning of the year, we were thinking that would be a 2023 event. But it's not just that it's the fact that issuers are starting to look at alternative places to fund themselves. And you know, it's been a great run for EM issuers, where the dollar market has been very cheap for them. But that period, that period is over so it may be time to look more deep into the local markets. When it comes to China that again, that could be another I wouldn't really call it a Black Swan event. But I would say it's definitely a structural transition that we're dealing with in that the Chinese growth model is not the same as it used to be. The recovery we've seen this time, post COVID and post coming out of the very long lockdown that they had, the recovery has been more consumption and services led and this is something that doesn't necessarily benefit EM in the same way as it did back, you know, when it was more a fixed asset investment, which was very strong for commodities, for reasons like Latin America are quite strong commodity economies. And so again, that's a bit of a conundrum. And the other thing about the Chinese recovery this time around is that there hasn't been a one big bazooka stimulus like there was before. It's been really, really piecemeal, really, really tailored, very sort of region- and, you know, sometimes city-specific and this has been the type of policymaking for the last really couple of years now, which is quite difficult to read as an investor. And I think, while slower growth in China is something that, you know, the market's been learning to live with for a while now, but the impact and the feed through to EM economies is still quite difficult to read, I would say. 

Peter: Thanks, Kathy. It's fascinating to appreciate actually the sort of different nuances and drivers across emerging markets and how the investment cycle differs across regions. I think that gives us a good view of the investment landscape and the challenges that lie ahead. But I suppose the key question is, how best for investors to navigate this environment? So Max, I'm going to turn to you again when you back into the conversation. So, it's time to decide which side of the fence you are on in terms of a hard or soft landing. And if it is a hard landing, when will this materialise? And with that in mind, last question, how would you allocate between assets?

Max: Thanks, Peter. So, I see myself slightly less in the business of calling the ultimate outcome, something that none of us can know for certain, and more being in the business of trying to identify market mispricings. And so, I think that, and I'm gonna echo what George was saying earlier on, it's first key to identify just how much the soft-landing narrative has come to be in the price today. Some people like to say that there are dislocations across asset classes, inconsistencies that, whilst credit or equities are perhaps pricing a soft landing or cyclical reacceleration rates with expectations of cuts next year, are already pricing a small probability of a recession. I think that would be the wrong interpretation. Firstly, I have more respect for markets than that. I think that we should always assume internal coherence and we're likely to extract a truer narrative if we impose this on ourselves. Secondly, I think it's clear that the cuts priced into the curve next year are victory cuts and not recession cuts. They're the sorts of cuts you would expect to occur if the FED felt comfortable about inflation falling in line with its mandate, and they felt that they could slowly ease off the restrictive stance that they have been on, you know, ever since they lifted rates aggressively in 2022. And so, for that reason, I think that markets at the moment, from a risk reward perspective, are skewed towards disappointment. The good thing about fixed-income is that the fixed-income products we're discussing today - the corporate bonds, the EM bonds, even government bonds - you know, have an inbuilt buffer for these periods of turbulence. And that buffer is particularly large today, when you know, the Federal Reserve has increased rates so dramatically, and the two-year bond itself is yielding 5% as we speak. What this means is (a) income generated for investors in fixed-income products and (b) the prospect of very large capital appreciation, when the economy slows or rolls over. It was very common early in 2022, to say that cash was trash, because it yielded next to nothing early in the year. And now that cash is yielding four or 5%, depending on the jurisdiction, some people think that cash is king. Our perspective on allocating assets is that it's in fact the opposite. It is not when cash is high that it is king, it is when the cash rate is increasing, leading to a derating of all financial instruments versus cash. And so it was that last year, even as everybody thought cash was trash, dollar cash was actually the best performing financial asset, perhaps alongside commodities. This year, however, even with a much more attractive cash rate, we think that investors will reap better returns from a combination of an exposure to interest rate risk and corporate risk. And that is exactly what bonds and the fixed-income universe in general offers. 

Peter: Thanks, Max. I think that's a really interesting take on where we are now and I particularly like the phrase victory cuts, I think that's something I shall remember. So, George and Kathy, do you agree with Max and his outlook? And if so, should investors be embracing or avoiding risky asset classes, such as high-yield and emerging market debt? And how are you positioning your portfolios for the potential turbulence ahead?

George: Sure, I could take that one, Peter. Thanks. So yes, we do, we do agree with Max that there's far too much optimism priced into today's market. We also agree that duration has been a headwind on fixed-income over recent years. But luckily, for corporate credit, especially this year, it's been offset by tightening credit spreads. We also do think that going forward, that the potential for a reversal of that headwind of duration is likely, considering the starting point. And that all leads to you know why we do like fixed income here. The high yield? Yes, it's classified as a risk asset, right? When you talk about risk assets, high yield is in that boat. But we think that that's a bit of a generalisation that fails to get granular on the various cohorts of high yield. You don't have to buy the entire market, you can buy certain parts of the market, and make sure that you have an investor that does so. So, do we think now is the time to load up on low-quality risk? No, definitely not. I mean, for all the reasons that I went through previously, we do not see value, in general, in low-quality risk. We think you have to be extremely selective there and do the credit work. It’s not the time to reach for yield in that part of the market, but we do see a lot of good opportunities in companies that yield seven to 10%. So, we're talking about equity-like income yields here and you can buy those companies and you're higher in the capital structure, investing and getting equity-like returns. So, you know, we do think that that is attractive at this point. Some of the things that we've been doing, you know, we are focused on quality. We have been taking down cyclical exposure, we'd prefer repeatable, forecastable cash flows - you know, companies such as an LNG facility operator with long-term contracted cash flows and that we have a lot of visibility into, or a software company with high retention rates - you know, those are the kinds of companies that we are looking for right now in favour of cyclical exposure. But really, at the end of the day, it comes down to minimising default risk as a manager, not reaching for yield, especially when valuations are skinny. And that allows us to capture those equity-like returns for our investors. You know, Max touched on this, and I think it's very appropriate, the beauty of our market, of the high yield market, and I know Kathy's market too, is this built in safety mechanism of a running yield. You know, that can cushion the downside return and it can also give you a head start on the upside. So, we saw that in 2008 and 2009, during the GFC, high yields outperformed equities on both the way down and the way up here in the US, which I think is a very attractive proposition to investors at this point. So, I guess the last thing I would say is that the high yield asset class, we've had a couple of years here where we've been calling it the high yield asset class, but the reality is, it has not been so considering, you know, three and a half, 4% yields - not really high, in my opinion, and many investors’ opinions. But now, as we are over 8% here in the US, right around eight and a half percent, the asset class is finally living up to its name again, and we do think it's attractive versus alternatives. 

Kathy: I really couldn't agree more with George and Max. And yeah, to George's point on the yield, this is where we should be. You know, it was absolutely fair enough for investors and asset allocators to take stock at the beginning of the year, following on from a year like 2022 - such a horrible year for all asset classes - and to process the rate hike. Fair enough to take stock, sticking cash, figure it out, you know. But now is the time to sort of be moving on from that. And in a historical context, the yields we have today, they make much more logical sense for the EM asset class. Back, say, 2018 levels, we were at a point where, you know, EM was yielding four and a half 5%. That doesn't really seem the right level. And now today, you know, we get more than 6% on IG, and in high yield we're around 9%. So, this feels like the buffer is there. In terms of spreads, because this debate over hard landing versus soft landing hasn't played out yet, we're nowhere near the tightest we've been, in terms of spreads in the last 10 years, and we're not at the widest. There is still some compression potential there. The challenge we always have in EM is convincing investors that it's not as risky an asset class as you would expect. Really, when you get into the details of it, and George alluded to this as well when you really delve into the different sectors of the US high-yield market, you don't have to be in every country as asset allocators with bottom-up selectors. You can choose not to invest in certain countries, certain regions. We, as we've been running our fund overweight, high yield for, since inception since 2010. But what we like to point out is that, when you look at EM high-yield issuers, they are not as risky as you would think. The balance sheets are actually often investment grade rated. They're only rated high yield because of the country rating ceiling. So, rating agencies will, their methodology is not to rate corporate issuers higher than sovereign. So, you've got plenty of, you know, corporates that are in single B territory in places like Turkey or Georgia, where yes, they have high inflation, yes, they may have weak effects. But these are management teams, which have learned how to deal with those very things, again and again over decades and know how to manage through a challenging operating environment. And one of the you know, the buffers against that is to keep a very low leverage. So, whereas in the US you might expect, okay, two issuers - one is double B, one is single B in the same sector, you kind of maybe expect the single B issuer to be higher leverage. That's not always the case in emerging market high-yield and really, it's quite nuanced when you get into it. But like George, you know, I'm not, I'm not piling into EM single B's all at once at the moment. Like George, we are very much dialling back, not having... it feels like it's not the time to have to stretch way down the credit curve to get a good yield. We're very happy being quite overweight double B's, that's where we find a lot of the situations where issuers have been downgraded because of sovereign ratings, and not because of the fundamentals of the credit. So, we're kind of happy to hang tight and double B's and, you know, an 8 percent overall yield in that asset classes looking pretty, pretty attractive.

Peter: Yeah, thanks both. So, you know, a relatively attractive entry point into the asset classes with the yield that's on offer and encouraging to hear that potential attractive opportunities still exist, especially if you can be selected through active asset management. Look, sort of wrapping up now. So, I think we've sort of covered exactly what we think in terms of hard or soft landing, the current sort of market pricing reflecting the outcomes and potentially, you know, where to be cautious and where to embrace risk at the moment across the fixed-income spectrum. So, let's wrap up now with a quick fire round and this should only require you know, relatively short answer so I'll start with:  Who do you think will cut interest rates first, the FED, ECB or Bank of England? Let's start that with Max and George and Kathy.

Max: I'm gonna go for the FED. I think that they have a sort of thought leadership role within global central banks and that they often provide the cover for other central banks to move in the same direction. They're also, I would argue, more advanced with regards to their cycle and their fight against inflation and I would expect them to open the ball when it comes to interest rate cuts.

Peter: Thanks, Max. George?

George: Thanks, Peter, I'm gonna give you the same answer that I would give you if you asked me who was going to win the upcoming Ryder Cup. And that is going to be the US is where I think we start. As Max had said, we're farther along in the rate cycle and not hamstrung by inflation as much as Europe or the UK.

Peter: And Kathy?

Kathy: Yeah, again, I have to agree with Max and George, it feels like the FED have been more practice through this through this whole cycle than ECB or BOE.

Peter: Okay, so who will agree then it's the FED to go first and that was a very controversial comment on the Ryder Cup, George. Luckily, it's not played on paper it's actually played on the course, so that's where teamwork comes into play. And the final question of the day is that in a recent survey, it was reported that coffee has replaced tea as the UK's favourite hot drink. So, what is your preference? Start with Max again.

Max: As you can hear, I do have some British blood but I was brought up in the South of France and, perhaps for that reason, every morning, I drink coffee. 

Peter: George?

George: So, I'm going to catch some heat from my friends here in America, but actually, it's tea for me.

Peter: Wow, that's unexpected. And you Kathy?

George: Non-consensus.

26:59

Kathy: I guess, you know, I'm not surprised by that stat. I didn't know it before but I'm not surprised. Because I remember, you know, a few decades ago, if someone came to your house, you'd wheel out the Nescafe, you know, which is not really proper coffee. We were, I don't think we were drinking proper coffee a few decades ago in the UK, but I'd say the coffee situation has improved vastly, but I'm definitely 100% a coffee drinker. Although, I actually need both. I need tea first and then coffee.

27:26

Peter: Yeah, actually, I'm in the same.... 

27:27

Kathy: Every morning. 

Peter: I'm tea first but I enjoy coffee later on. But if I had to choose one and exclude the other one for the rest of my life, I'd stick with tea. So, that's two each on the tea or coffee scale there, which I guess sort of shows up the sort of imbalance or the uncertainty we're seeing in markets at the moment. You know, it's reflecting that there is sort of both sides to an argument, but it'll be interesting to see which one plays out over the next month to come. And on that caffeinated bombshell, this concludes this episode of abrdn's Fixed Income Explained podcast. I hope we are providing some context around current market conditions and the potential path ahead. I would like to thank our guest speakers for their valuable insights. So, thank you everyone. If you'd like to find out more about abrdn's latest fixed income views, you can subscribe to our fixed income newsletter by using the link below. And you can also access previous podcasts also by clicking the link below. Thank you very much for listening and goodbye.