Global bond markets are vulnerable to economic growth disappointing and inflation ticking up higher than expected, according to Noah Wise, senior bond portfolio manager at Allspring.

“There’s a lot of cross currents in the market: we see some risks to both the growth and the inflation outlook and we see a market that is increasingly not pricing any of these risks in,” Wise (pictured) told FSA in an interview.

On the growth side, he pointed to a weaker than expected US labour market and consumption growth slowing, and noted China’s struggles to reignite growth coming out of its property market downturn.

When it comes to inflation risks, the US economy still faces upward inflationary pressure from its immigration and trade policy that has been mostly dismissed as a one-off effect.

But in Wise’s view, the market underestimates that “the one-off can last a little bit longer than it fully appreciates at this point”.

He said: “It’s not that it is a permanent and a continuous risk, but it is something that may take multiple quarters, if not a year, to feed through, and the market is already looking through it before the full effects have been felt by the economy.”

Opportunities still exist

Wise said that while it’s “not a disaster anywhere” there is downside risk to growth and upside risk to inflation, “and when we look around markets, we see all-time highs, we see credit spreads near all-time tights and we’ve seen rates rally”.

While there are still pockets of opportunity in different sectors, Wise said he is dialling back risk because “investors are not being compensated for the risks that we see on the horizon”.

He said: “Based on the research that we’ve done, the odds favour investors reducing risk into these types of valuations because the excess returns tend to be negatively correlated to these spread levels, and the volatility and the risk metrics tend to be positively correlated.”

“So we think it’s a time to respect history in the markets and be disciplined and not take too much risk at an inopportune time, because that can constrain and limit what investors can do in terms of being able to take advantage of future opportunities when the market does become surprised.”

One way to manage asset allocation within a fixed income portfolio would be to move up in quality, according to Wise.

“We don’t view this as a time to be taking a disproportionate amount of risk in high yield markets when the incremental spread for investing in BB securities versus BBB securities is also at a cyclical low point,” he said.

“We think it is a time to be able to move up in quality. So along that vector we are taking a little bit less risk.”

A sector not trading at historical tights

One area that Wise is overweight across portfolios is agency mortgage-backed securities, a sector he says is not trading at historical tights.

“They’re not the cheapest that they’ve ever been, but they’re not the richest that they’ve ever been either,” he said.

“Compared with their own historical valuations, they’re pretty close to the average, which wouldn’t necessarily be a ringing endorsement, except when you compare it to a lot of the alternative spread sectors.”

One reason the sector is not trading as tight as other corporate bond sectors is due to the implied interest rate volatility embedded in the price – however Wise believes interest rate volatility will likely move sideways or down from current levels.

He added: “The agency MBS sector is a higher quality, more liquid, sector – a place that you can kind of hide out in some higher quality securities where you can get income that we think in this market is a little bit more stable.”

“In our view it is not a good time to be digging into the deeper parts of the credit quality spectrum.”