Tapping into the bond attraction
This article first appeared on Octomembers.com on 17th November 2022 “How do you prepare for the...
M&G is not only the largest fixed income house in the UK, but it is also home to the most well-known UK bond fund manager, in the shape of Richard Woolnough.
Richard recently presented his views on the M&G Optimal Income fund and the wider global economy in general, so we jumped at the chance to gain some of his insights.
I wouldn’t say we are avoiding high yield as such, as we think it is fair value, but we think investment grade bonds are better value right now.
Also, the [combination of the] search for income in a low-yield environment, and the European Central Banks buying corporate credit, has distorted the market and, as a result, we don’t buy European credit if the main issuers are in Europe – but we will own it dollars, as it trades cheaper.
Emerging markets have also started to get expensive again. We have been reducing our holdings this year and we have now started buying protection against some of the emerging market credits out there because they face stresses. We await the outcome of the trade wars between President Trump and China, but if he wins it is obvious that whatever he gets China to do, he’ll try to do to someone else too.
In terms of a recession one of three things we look at is the year-on-year increase in the oil price; because when the oil price goes up, we get a slowdown. Essentially, we all become poorer as we have to pay more for energy. Central banks don’t see this and, as a result, they always put interest rates up.
The second factor is the US housing market. When there is too much housing inventory the price is correct. We were very worried towards the end of last year about the excess levels of inventory (over seven months inventory of housing relative to the labour market). This has since come away again, but we continue to monitor this and when it does go above seven months, it is always a warning sign. The third is an inverted yield curve – when all three are in place we would consider it an amber light over fears of recession.
It could be different this time though. This is a very different economic cycle to those we’ve seen previously. Normally interest rates get cut, banks lend lots of money and it transitions into the housing market. However, if you look at housing market data in the US, this cycle has not been driven by the US housing market. Looking at the number of people working in housing and construction is normally the swing factor – that’s not the case this time as the market has not been as aggressive.
The impact of oil prices might also be different for parts of the globe. For example, it won’t affect the likes of the UK, as we have alternative sources.
Trade wars are the worst thing that can happen from an economic standpoint because they means less is produced and inflation increases. So far, it’s not too important as it is only one area affected and the US and China can absorb that strain. Questions will be raised if it escalates. Also, trade barriers can result in an inefficient allocation of resources – which results in higher inflation and lower growth.
Much depends on the outcome – will it result in free trade or trade barriers around the world? If you are going to be strict on trade barriers you want to do it when you’ve got full employment and reasonable growth, you don’t want to do it when GDP is 1% and the move results in it falling to 0%. It will affect some countries more than others.
This depends how you define far left. It has implications for various sectors. They clearly have different attitudes to the likes of water and utilities in general, but you don’t know the true impact until it happens. If a political party decides to nationalise the water sector what happens to your place in the capital structure? If you’re a bondholder, instead of receiving your 3% coupon each year over the next 40 years from Thames Water, you get in from the Government – you make a gain, but, if they decide to nationalise, you’ll make a loss. If you are in the equity part of the capital structure you might get crushed as they look to determine what fair value to buy is. You’ve also got legal and risk issues as well as regulatory involvement.
So much can happen, you’d really have to wait and see – but the one thing it would do for certain as a fund manager is it would create a mis-allocation of pricing. It will then be our challenge to take advantage of that mis-allocation, particularly in the sterling bond market.