272. The economic tightrope: recession risks and interest rate dangers

24 August 2023 (pre-recorded 15 August 2023)

Below is a transcript of the episode, modified for your reading pleasure. Please check the corresponding audio before quoting in print, as it may contain small errors. Please remember we’ve been discussing individual companies to bring investing to life for you. It’s not a recommendation to buy or sell. The fund may or may not still hold these companies at your time of listening. For more information on the people and ideas in the episode, see the links at the bottom of the post.

[NTRODUCTION]

Staci West (SW): Welcome back to the ‘Investing on the go’ podcast brought to you by FundCalibre. This week we’re focusing on the ongoing macroeconomics influencing the bond market and why today’s guest believes markets are underestimating the future impact of interest rate hikes and therefore anticipates a recession.

James Yardley (JY): I’m James Yardley, and today I’m joined by Mike Riddell, the Elite [Rated] manager of the Allianz Strategic Bond fund. Mike, thank you very much for joining us today.

Mike Riddell (MR): Thanks for having me.

[INTERVIEW]

JY: So, Mike, I think yours is a genuine strategic bond fund. You don’t just invest in credit, you look at the big picture. You take a flexible approach, and you are very much focused on the macro environment. I believe since early 2022, your view has been that we’re underestimating the risk and depth of a recession. So, what is your big picture view today? Do you still have that view that we’re still heading to a recession?

MR: Yeah, I mean, first of all just on what the fund’s trying to achieve, and as you touched on, we are trying to be very flexible throughout the economic cycle. We are macroeconomic, top-down investors. So, as you say, we’re trying to understand the direction of the global economy and then look at what’s priced into markets, and then see where we disagree. We do have, as you say, genuine flexibility. You know, back in 2020, at one point we behaved like a riskier corporate bond fund, and that was back when markets were pricing in a great depression forever, and we thought that actually, we’re going to get a v-shaped recovery from second quarter of 2020. But at other times we can be positioned for things to blow up. It doesn’t mean that we need things to blow up to make money, but it means that we believe that what is priced in is missing the risk of recession. And actually, that was the case in January / February of 2020. We thought Covid would cause a big recession and markets are pricing in no risk of recession.

Now, where we are today, actually our view is not that different to where we were at in February 2020, and indeed the portfolio [is] positioned fairly similarly. That doesn’t mean that I’m expecting a Covid-style financial crisis necessarily, but I think what’s priced into markets today is really no risk of recession.

So, within our fund, we can go into government bonds, corporate bonds, we can take inflation views, we can even use currencies as well. And almost every market we look at, we can see market are not really pricing in much recession risk. So, just to give a couple of examples; if you look at corporate bonds, so normally the extra yield you get on corporate bonds over government bonds kind of tracks the economic cycle. So, if markets or investors believe there’s a risk of recession, then so-called credit spreads are very wide, in other words, you’re getting much more yield on a corporate bond than a risk-free government bond. But when there’s no perceived risk of recession, then you find that that extra yield in corporates is very little, in other words, credit spreads are very tight. And where we are today, we’re actually seeing risky assets like corporate bonds, saying no real risk of recession. The extra yield you’re getting on corporate bonds over government bonds is in line with the average of the last 10 years. So, that’s the market really implying that we’re going to have moderately strong growth over the next 1-2-3 years. So, that’s just on corporate bonds.

But actually, if you look at government bonds, you get a similar picture. I mean, government bond yields are very high. Government bonds have had the biggest sell-off really in history over the last couple of years. It’s been incredibly violent. Yields have gone from historic lows to really the highest in a few decades in some cases. I just saw just today, French government bond yields are now today the highest in over 12 years. So, we’re seeing very elevated government bond yields. People might assume that’s because inflation is very high, but actually inflation’s been coming down really quite quickly – and the UK’s a bit of an exception here – but if look at the US: in the US, inflation is just above 3% and it was almost 10% in [the] summer of last year. Similarly in the Eurozone, inflation got to above 10[%]. Today it’s just above 5[%] and it’s continuing to move lower. So, we’re seeing really inflationary pressure go away. Inflation markets are saying that there’s not really any inflation problem. I mean, markets are always forward looking and they’re basically pricing in inflation moving back to target in the next one or two years.

So, the reason that markets are expecting interest rates to remain extremely high, we believe is because markets think growth is going to remain very strong. And this we just do not agree with. So now, as you said, our view has been we expect a recession. We don’t know exactly when it’ll happen – and that’s been our view really for 12 months and actually, so far, there hasn’t really been a recession, we can get into that maybe a bit later – but we believe that all of these rate hikes which we’ve seen – and we saw more aggressive interest rate hikes in the UK and the US in the early ‘80s – but actually globally, we’ve seen the most aggressive interest rate hikes we’ve ever seen.

What people or what markets anyway don’t seem to appreciate is that it takes at least 12 months for an interest rate hike, or indeed an interest rate cut to have any impact on the economy. So, you know, we’re probably going to see in September, the Bank of England hike interest rates again. But the economy won’t feel that until September of next year. So, we have all of these hikes that we’ve had over the last 12 months. They haven’t really caused a slowdown yet, but they’re about to. So, this is why we do expect you know, a recession and when we look at what markets are pricing in – really any market you like – it’s just simply not pricing in that risk of recession.

JY: So, if I can just sort of summarise for our listeners there, I think what you’re saying is you are seeing very good value in government bonds, with markets basically pricing in quite high interest rates, quite high growth going into the future, but poor value in corporate bonds. So, the extra spread you’d expect on top of a government bond, not really pricing in much risk at all. So, your fund is currently, I take it, heavily invested in government bonds with little or no corporate exposure or even, are you even short corporate bonds at the moment?

MR: Yeah, we are actually, and within our fund we have the flexibility to not just be underweight of corporate bonds versus a benchmark, but we have the ability to actually go a bit short as well. So, today, about 20% of our fund, and we wouldn’t go really any higher than that, but 20% of our fund is outright short of corporate bonds. When I say short of corporate bonds, it’s really that credit spread, it’s that extra yield you get over government bonds. So, you know, people might think shorting means increasing the risk of your fund, but given that credit spreads aren’t really … they’re not wide, they’re actually fairly tight then, you know, if we are wrong, we can’t really lose much because they’re already quite tight. There’s very little downside from what we’re doing, but if things really blow up, we could make a lot of upside.

So, that’s a kind of asymmetry we really like, where if we’re wrong, we don’t lose much, but I think that where we are today in markets – if we’re right about recession – then we could make a lot of money exactly.

Just a point on corporate bonds as well. I mean, where we disagree is exactly as you said, it’s that extra yield over corporate bonds versus government bonds. It may well be that corporate bonds have a positive return in the next year or two, and I wouldn’t be entirely surprised if they did, but the risk-reward I think is much better in government bonds because, you know, you’re better off having the risk-free – [they really are] risk-free yields of or 5% in the case of the UK, and near that in the US too. But risk-free, you can get around 5%, but to go into really quite risky companies, you might only be getting a little bit of extra yield, where if things blow up and things repriced and there’s recession, then you could actually lose a lot just as we did in, or anyone who was invested in corporate bonds, in March 2020.

JY: Yeah, and when you are talking about risk free government bonds, of course you are talking about the credit risk, not the interest [risk].

MR: Exactly – sorry – correct. I mean as we’ve learned in the last two years, then you know, there’s definitely risk involved with buying a government bond and you know, interest rate risk is something which sometimes it can be really bad and indeed the last two years it’s been really bad, but we like interest rate risk right now – it’s called duration in the bond world – we really like interest-rate risk because if interest rates do start coming down and come down more aggressively than markets are pricing in, then that’s where you can get really big capital gains. So, you know, yields going down means prices going up and potentially by a lot. And we are really positioned about as bullish as we can be on government bonds, where we really like interest rate risk because we think that markets are simply wrong.

And to put some numbers around this; in the US ok, the Federal Reserve has interest rates above 5%, but the market is saying never again in the next 10 years at least, is the US going to have interest rates below 3.5 [%] – ever. In the UK similarly, the market’s saying that the Bank of England’s going to keep interest rates above 4% for a number of years, and this is what we disagree with, is that at some point in the next year or two,  when they know there’s not really an inflation problem anymore – which is our view and indeed seems to be what inflation markets are pricing in – but at some point, something will happen; there could be some kind of crisis, but in particular, if there’s a recession, why does the Bank of England have to keep interest rates at 4% or 5%, if growth is negative and inflation’s at target? It doesn’t make any sense to me, but that is exactly what’s priced in. So, if we do start to see interest rate cuts coming through next year and something does happen, then that’s where you can get really big capital gains in owning government bonds.

JY: Have you been a bit frustrated at how long this is taking to play out though? I think a lot of investors have been surprised at the resilience of the US and the UK economy and, how do you view this from now? I mean, are you just being patient? Are you happy to just wait and accept some short-term losses for potentially greater gain in the longer term?

MR: Yeah, that’s exactly it and we are extremely frustrated! We’ve been positioned defensively for the last 12 months, if not more. And really, thinking about how markets have behaved over the last 12 months, remember, last summer we did have quite high inflation and actually risky assets were pricing in a bit of risk of recession, but not fully pricing it in. And then we went down to this narrative of high inflation, interest rates are high, risk of recession. Towards the end of last year, markets moved towards a soft landing; by February, they’re basically pricing in ‘no landing’, as in there will not be a recession. Then we had the US banking crisis, we briefly went back to a soft landing or a slight risk of recession priced in, and now today it feels like we’re back to no landing again. So, the market’s saying there will not be a recession. So, clearly given that we’ve been positioned for a recession, when markets go from pricing in moderate risk of recession to no recession, that’s obviously bad for us and our fund has underperformed over the last year. So, it is really about patience, as you say. We still have very high conviction that at some point we’ll be right. And it might be that we are wrong over the short to medium-term – and we have been wrong over the last 12 months – but we still believe we will be right.

To go into why we’ve been wrong, which I think is obviously very important to understand what’s happened, I think people haven’t really fully realised how much of a positive economic surprise or economic shock it was that gas prices have completely collapsed since [the] summer of last year. So, European gas prices have fallen by over 80%. Now that is an enormous positive economic shock and indeed the Bank of England earlier this year revised up their GDP forecast, their growth forecast, for this year by the most in their history. So, this is a really positive economic shock. And there are other things as well that happened earlier this year; we had very mild weather in the US, that produced a bit of a positive growth story for the US. China opened up, that was good news for China’s economy, which helped the world a bit in Q1 and a bit of Q2. So, there have been quite a lot of positive surprises for the global economy.

But where we disagree with what’s priced into markets at the moment is that markets are seeing this lack of recession in the last 12 months and therefore concluding that there will therefore not be a recession. In other words, interest rate hikes do not matter, they don’t do anything. Now, this is where we completely disagree. Now, as I mentioned, we think that they will;  they will bite and they will bite hard. It’s just that we’re only feeling the nibbles at the moment; it’s going to be tearing chunks off us quite soon, given these lags between interest rate hikes and when it really has an impact on the economy.

So, we are absolutely having to be patient. You know, I’m happy that actually our investors have been patient too, given how badly bonds have done and our fund has underperformed as well. I think people do buy into our view and, you know, they have a long-term time horizon like we do. But obviously we need to be right eventually, but you know, we think that by this time next year, if there is not some kind of recession, I’ll be extremely surprised.

JY: Yeah. So, that was going to be my next question, how long do you think we’ll have to wait? And if and when it does come, then how big is this recession going to be potentially, or do you not worry too much about that?

MR: The time horizons and the lags, you know, they are long and variable as central bankers always say, between hiking rates or cutting rates and what happens to the economy. Just as we’ve seen really the lesson of the last 12 months is that stuff can happen and then that can change your view of the risk of recession imminently or, you know, might have happened further in the future. Now, there could be things that could happen in the next few weeks which make a massive recession imminent. You know, Putin might do something crazy or China indeed, you know, the geopolitical risks are huge, and these could cause a recession and crises very, very quickly if things go wrong.

There are scenarios where maybe the world does avoid a bad recession or maybe really doesn’t experience much of a recession. And I think that the only way I can really see that happening is if inflation falls even more than we think it will. So, inflation falling – and particularly commodity prices falling – is, as we’ve seen in the last 12 months, is a really good growth story for the consumer. I mean, if your cost of inputs, if you’re a company like, your cost of petrol or electricity or whatever it is, if these prices keep falling, that is just good news for you. If you’re a consumer and you have a big fall in petrol prices, then that’s like a windfall gain for you. You know, you get making more money out of that as a consumer, you’ve got more money to go and spend on other things. So, if we keep seeing inflation falling, and falling maybe even below target in a year’s time – that could really happen in the US, it might happen in Europe, but slightly less likely – then maybe we will avoid a recession.

But even in that environment, I think you’ll see a good rally in government bonds because inflation is really the enemy of government bonds. So, if we see inflation fall sharply, we might avoid recession, but I think we’ll still get a government bond rally anyway because central banks can then start cutting rates because inflation’s gone away.

In terms of what might make this recession worse, I mean, there are always risks and shocks and a shock is always an unknown unknown. I mean, it’s always a surprise when it happens. I guess the known unknowns, if you like you know, what’s happening in China has actually been quite alarming. I mean I’ve been a China bear for well over a decade. I mean, a decade ago people were talking about China growing at 8% forever and overtaking the size of the US economy in the mid 2020s. I mean, this to me was always a complete fantasy. China’s demographics have been deteriorating for a number of years. Their working age population is actually shrinking. This is what happened in the developed world in ’07, ’08, it’s what happened in Japan the early 1990s. Now, it did not seem possible to me that China could grow 8% when it’s got more people leaving the working age population than joining it. So, then you can think about debt levels; Chinese debt levels were on a par with Spain in ‘07. And again, private debt levels in China were the same as Japan in the early 1990s. So again, when debt levels are really high, it’s very hard for an economy to grow very quickly. And I think what we’ve seen in China in the last couple of years is that finally the authorities have let the property bubble go, if you like. For the last 10 years, every time the housing market began to fall, then they’d just create another bubble – we’ve really had four or five credit bubbles in China since 2008 – this time they haven’t done it and they’re trying to really cleanse the system, but we’re seeing how painful that is.

So, I think there are a lot of similarities of what China’s going through with what the rest of the world went through in – well, [the] developed world I should say – went through in ’07 and ’08 and what China itself went, sorry, Japan itself went through in the early 1990s, where you’ve got an ageing population, you’ve got a real estate bubble that’s popping. And, so far ,they’ve actually managed it fairly well. We haven’t had a crisis in China, but you know, just in the last few days and weeks, we’ve been reading about more problems and you know wealth management products and all sorts of products defaulting … the biggest real estate and developer in China looks like it’s on the brink of default as well, called Country Garden [Country Garden Real Estate Group Co Ltd]. So no, I think there’s a lot more news to come out of China, which could destabilise the global economy, not just China or Asian economies. So, that’s a risk out there, which we think is very front of mind.

But I think otherwise the main risk of recession is really just around interest rates. And as I say, all those hikes over the last year which are going to start biting, start causing some pain for the consumer, corporate earnings are going to start to fall. And a lot of companies, and a lot of people who had mortgages, were turning out their debt in 2020. So, you know, people would, you know, maybe they had a floating rate mortgage in 2020 when interest rates were slashed after Covid, maybe some of these people then actually moved their mortgage to a 2-year, 3-year, or even 5-year fixed rate mortgage. And companies were doing the same thing with the debt that they had – companies were issuing new debts with longer maturities. And what this means is that it pushes out how long it takes for you to [feel the pain when] refinancing this debt. If you borrowed for five years at 1% in 2020 – these interest rate hikes aren’t going to hurt you. When they’re going to hurt you, it’s when you have to refinance this debt. And I think we’re just on the cusp of this for a number of companies, where a lot of companies who are borrowing for 2 years or 3 years or 5 years in 2020 and 2021, are about to start refinancing debt. When they borrowed at 3[%] in 2020, they’re now having to refinance that at 8[%] or 9[%], and that’s going to start causing some big problems. So, I think that that’s really going to be a big story for the next 12 to 18 months as we start to see some companies and indeed some consumers, maybe mortgage borrowers, get into a bit more difficulty than they’ve had so far.

JY: Well, Mike, that’s been really interesting. You’ve given us an awful lot to think about there, but it’s always good to hear your view and thank you very much for joining us today.

MR: Great, thank you.

SW: The unique characteristics of this fund sets it apart as a strategic bond fund. With limited correlation to equities, it truly provides diversification opportunities for an investor’s portfolio. To learn more about the Allianz Strategic Bond fund, please visit fundcalibre.com