03 Jun 2020
3 June 2020 | Ariel Bezalel and Harry Richards, Head of Strategy, Fixed Income and Fund Manager, Fixed Income
Ariel Bezalel and Harry Richards answer five common questions about global bond markets and Jupiter’s Flexible Bond strategy.
Ariel: The Federal Reserve is buying vast amounts of Treasuries through unlimited quantitative easing and has crossed the Rubicon with its plan to purchase corporate bonds for the first time. We think there’s a real possibility they go even further and start buying even lower quality high yield paper to support the market.
With such aggressive policy backstopping risk assets, it’s hard to see what could drive another liquidity crisis in the near future – Janet Yellen has even recently advocated giving the Fed the necessary powers to buy equities. This is something the Bank of Japan has been doing for some time, so it isn’t without precedent. Everything is on the table.
However, central bank policy has solved the liquidity problem but not the looming solvency problem. US companies are sitting on record amounts of corporate debt to the tune of about 50%-75% of GDP. Some of these highly indebted companies simply won’t be able to survive in a lower growth environment operating at 30%-50% of their capacity. Even if governments intervene with more fiscal stimulus, a big problem for these companies is going to be dwindling demand given uncertain job prospects and the likely rise in precautionary saving among households and corporates. So, having had the ‘liquidation phase’ in March, we expect we’ll see an ‘insolvency phase’ later in the year as bankruptcies start to rise and companies move to restructure their debt.
Harry: We’ve already increased credit risk in the strategy. The allocation to investment grade credit has jumped from about 9% before the crisis to about 16% today. It’s difficult to justify being short credit given policymakers have said they’ll do ‘whatever it takes’ to backstop companies. That’s why in March, when fiscal and monetary stimulus was looking likely, we unwound the 10% CDS short positions on US and European high yield and investment grade markets. We used market weakness to buy high quality investment grade credit with resilient top and bottom lines that we think can survive throughout the business cycle. This has included bonds from the likes of McDonalds and AB InBev and adding to our position in Tesco – we’ve called this our “beer and burgers” theme. Within high yield, we’re sticking to more defensive senior secured debt and BB-rated bonds – again in ‘through-the-cycle’ businesses, like Netflix, Virgin Media and Pinewood Studios. We’re using any market weakness to add to quality credits.
The reason overall duration remains the same at about 6.5 years is because we’ve kept the allocation to high-quality, longer dated US and Australian government bonds as a hedge against deflation. Growth expectations ultimately drive bond yields. We think we’re heading for zero per cent or even negative yields on the US 10-year over time, as people realise that global growth is going to struggle. We will inevitably have some sort of bounceback but the powerful structural drivers of too much debt and aging demographics are still very much intact. In fact, the reaction to the pandemic has reinforced the debt problem as government indebtedness has gone into overdrive globally.
Ariel: No, because the aggressive monetary and fiscal expansion is happening everywhere, not just in the US. Another factor that should continue to underpin dollar strength is the estimated $13 trillion of outstanding dollar-denominated debt in emerging markets1; As the economies of these countries slow down and they slash their interest rates, their currencies depreciate, which in turn makes it harder for them to service this dollar debt. Further exacerbating this, with the US in lockdown there are simply fewer dollars flowing to the outside world. So, we think the dollar’s strength will continue medium-term, although it won’t be without volatility.
In the longer-term, the US dollar’s status as the world’s reserve currency does look vulnerable the further it continues to strengthen. In 1985, France, West Germany, Japan, the UK, and the US all signed the Plaza Accord in a joint effort to devalue the dollar. I wouldn’t be surprised if something like that happens again, especially with China vying for superpower status with the US. But that’s much further down the line.
Ariel: We do have concerns about emerging markets, many of which are vulnerable to the strong dollar, falling commodity prices, slower Chinese growth, and have weaker infrastructure to cope with the Covid-19 fallout. There’s an ongoing debate about debt forgiveness for the poorest emerging market economies and I think this will become an increasing concern.
Another big concern for emerging markets is the collapse in tourism. Tourism accounts for around 10% of global GDP. After 9/11, it took seven years for airlines and travel spending to return to its pre-shock peak. We don’t yet know the full extent of how consumer behavior will change in response to Covid-19 and how it could compare to an event like 9/11, but the collapse in tourism is likely to weigh on emerging markets, and the global economy, for some time to come.
In the strategy, our exposure to emerging markets is around 10%. We have a 1% short on emerging market debt in the form of credit derivative swaps. We cut our exposure to local currency Egyptian sovereign bonds, given the economy is heavily reliant on tourism. We’re focused on themes within emerging markets that we expect will persist throughout the current crisis. We’re still very constructive on debt from protein producers – global demand for beef and poultry from producers in places like Brazil continues to be strong. We also have some exposure to short-duration emerging market US dollar sovereign bonds, for example in Ukraine where we believe funds from the IMF is forthcoming.
Harry: In our view, the enormous levels of easing we’ve seen so far shouldn’t really be considered outright stimulus, but more as attempts to replace lost output in a locked-down world: the global economy has effectively been put on life support.
While this easing has helped to calm markets, we think the huge supply and demand shock caused by the virus will inevitably lead to more corporate defaults, delinquencies on consumer loans and worsening unemployment over the coming months. There might be a bit of a spike in economic activity when lockdowns ease, as consumers begin to buy goods they held off on during the lockdown and return to cafes and restaurants, but in our view this isn’t likely to be enough to drive meaningful inflation. Given the deteriorating employment picture as well the risks of a second wave of infection, both consumers and businesses will likely want to save more and spend less, which is inherently deflationary.
Furthermore, corporate stress is prompting management teams to place a keen focus on cutting opex and capex in an effort to preserve liquidity and avoid insolvency if at all possible. As companies right-size their cost bases for the new environment, the possibility of seeing any upward pressure on wages is increasingly slim. As a result, if the unemployment rate remains elevated and employees have little-to-no pricing power, consumption will slow sharply as we are already witnessing in the data. Typically, corporates, the labour force, and the consumer take a long time to heal in the aftermath of a crisis which suggests that this deflationary pull-back in demand will be with us for some time to come.
Since governments and central banks continue to suggest they’ll do ‘whatever it takes’ to keep economies afloat, we think more easing is likely as we uncover the true scale of the economic damage in the data over the balance of the year and beyond. With monetary policy already at its limits, we could see more unconventional measures like yield curve control or negative interest rate policy being adopted on a broader basis and, eventually, policies such as Modern Monetary Theory (MMT) or ‘helicopter money’ may even be considered.
In the near term we have high conviction that deflationary forces have the upper hand but looking further into the future, we must remain alert to the potential introduction of policies that could prove inflationary.
If inflation were to become a material concern, we would use the full flexibility of the mandate to reposition the strategy to perform in that sort of environment. But we think that point is still a few years in the future. Until then, with the deflationary drivers of too much debt and aging demographics still intact, we continue to hold a substantial position in AAA-rated government bonds, alongside defensive and highly selective credit opportunities.
1Bank for International Settlements
Please note: Market and exchange rate movements can cause the value of an investment to fall as well as rise, and you may get back less than originally invested. The views expressed are those of the individuals mentioned at the time of writing are not necessarily those of Jupiter as a whole and may be subject to change. This is particularly true during periods of rapidly changing market circumstances.
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