How should fixed income investors position to manage upside inflationary risks and rising rates?
Significant uncertainty clouds the outlook as the global economy confronts a shock that is negative for growth and will likely spur further inflation. In our latest Cyclical Outlook, “Anti-Goldilocks”, we note that in our base case, growth remains supported by the post-pandemic economic reopening and pent-up savings bolstering demand, and inflation may peak in the next few months and then moderate gradually. However, there are obvious risks to this outlook, especially if the Russia–Ukraine war escalates further, including the risk of a recession over the cyclical horizon. The war in Ukraine and sanctions will likely lead to a greater dispersion of growth and inflation outcomes among countries and regions. Most central banks seem determined to fight inflation more than support growth, and we expect relatively muted fiscal policy support from governments over the cyclical horizon.
In this uncertain environment, our investment strategies tend to favor portfolio flexibility and liquidity to respond to events and potentially take advantage of opportunities. We expect to target modest duration underweights and to de-emphasize curve positions. We do not expect to have large positions in risk assets given market vulnerabilities, but we may add to spread risk opportunistically in select investments that we see as default remote. We continue to see U.S. Treasury Inflation-Protected Securities (TIPS) as a reasonably priced way to mitigate upside U.S. inflation risks. We may see meaningfully higher commodity prices as buyers look to reduce dependency on Russian exports. Commodities can also play a role in mitigating upside inflation risks.
What are the biggest income opportunities you foresee across the fixed income universe this year?
Amid this difficult and uncertain environment, a key plank of our investment strategy will be to emphasize portfolio flexibility and portfolio liquidity. We believe there is significant option value in having the risk budget space and liquidity available to respond to events and potentially take advantage of opportunities.
Credit positioning in portfolios should focus on resiliency, liquidity, and principal preservation for a wide array of scenarios. We will look to be underweight generic corporate credit. First, there are several areas of securitized products markets – such as in the U.S. residential mortgage-backed securities (RMBS), asset-backed securities (ABS), and commercial mortgage-backed securities (CMBS) markets, with a focus on U.S., U.K., and select higher-quality European collateral – that we believe offer higher credit quality or more default-remote alternatives to corporate credit. Second, within the corporate credit sectors, we expect to continue to favor senior financials: Recent weakness should provide the opportunity to add risk, with careful scaling, in the large global banks where the risk of default appears low, even in an environment of much higher volatility. In credit markets we will likely maintain a bias for the U.S. over Europe and EM given lower exposure and vulnerability to the unfolding events in Russia and Ukraine. And we continue to emphasize liquidity when expressing credit beta and focus on the highest-conviction and most resilient cash corporate bonds identified by our global credit team.
On the currency side, in portfolios where these risk positions fit with our clients’ guidelines and expectations, we expect to overweight select G-10 and EM currencies with a focus on commodity beta and cheap valuations. Finally, on emerging markets, more generally, we expect to have limited exposure but continue to seek attractive opportunities in a difficult environment.
How should investors think about market volatility as they look to generate income?
Over the long term, to target returns higher than the stated yield, you typically need volatility, which causes the markets to overshoot fundamentals. Although it can feel challenging when you’re in the midst of it, periods of heightened volatility historically have tended to provide the opportunity to generate not only a consistent and high dividend yield, but total return as well. This environment allows us to source attractive risk after a couple years of tight spreads. But we approach this prudently, looking to preserve capital.
The Fund Selector Asia Investment Forum Thailand was held virtually on 24 March 2022 and was sponsored by Columbia Threadneedle Investments, Matthews Asia, TT International and Pimco.
Find out more about what was discussed and the strategies that were presented here: https://fundselectorasia.com/events/fsa-investment-thailand/