346. Navigating rate cuts and inflation: tactical strategies for a volatile market

13 February 2025 (pre-recorded 12 February 2025)

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.

[INTRODUCTION]

Staci West (SW): Welcome back to the Investing on the go podcast brought to you by FundCalibre. We’re shifting our focus to fixed income this week with markets constantly shifting and interest rate cuts in the spotlight. Our guest shares valuable insights on navigating volatility, finding opportunities and managing risk.

Chris Salih (CS): I’m Chris Salih and today we’re joined by Stuart Edwards, manager of the Elite Rated Invesco Tactical Bond fund. Stuart, once again, thank you very much for joining us today.

Stuart Edwards (SE): Hi Chris. It’s a pleasure to be here.

[INTERVIEW]

CS: Let start with sort of a broad base of explaining the fund to the listeners. So obviously this is a sort of a go anywhere, do anything type of fund in the fixed income sphere, it has lots of strings to its bow. I think we’ve talked in the past about the sort of three components that make up the fund and sort of a bit more on the top down, bottom up. Maybe just spend a couple of minutes giving us an overall view on how the fund actually works and what you’ve been doing in the sort of past 12 to 18 months on it.

SE: Yeah, sure. Look fixed income or bond markets, it’s a very broad church. It means lots of different things to different people. Some people use fixed income as a sort of safe haven part of their portfolio. Other people use it to tap into more risky parts of the markets. So corporate bonds, for example, which can include high yield bond markets, which is low higher risk corporate bonds that this fund is due is designed to tap into all of the different elements in the areas of the bond markets. It’s, as you said, it’s extremely flexible. And it’s designed to take advantage. I guess from what is effectively a very volatile macro economic environment, as I’m sure all your listeners are very aware.

So what does it look like in practice? Well, I think there are three components essentially, as I said, it can tap into a broad universe. So it can adopt different interest rate strategies. We can manage the duration of the fund. It can take advantage of opportunities in corporate bond markets. So that’s investment rate, which tends to be higher quality and high yield. But also emerging markets as well if we feel that we’re getting rewarded for taking the risk. So, you know, the starting point, it depends on our fundamental view of the world, how much risk we want to take and where we see attractive valuations. And then the second component I’d say is flexibility.

This is called the Tactical Bond fund and in that sense, it does what it says on the tin. It can at times be very tactical. We can be flexible without allocation, but also our duration or interest rates exposure and we can sort of take advantage when we think that yields have gone too high. We can add duration. And similarly, if we feel that the market, the bond market has routed too much and yields have fallen too much, then we can take some of that risk off. So flexibility is absolutely key. And then the third component I would say the fund is downside aware. So, what does that mean? Well, if this was a more sort of generic corporate bond fund, then you are paid or expected to be invested at all times in corporate bond markets. With this fund we will invest in certain areas. As I said, it could be investment grade or high yield corporates or emerging markets, if we see value. In practice, that means that perhaps the hurdle for taking risk is a little bit higher than it might be for a more generic corporate bond fund. And equally, the hurdle for reducing risk might be a little bit lower. So, you know, that’s how our approach, we can’t obviously promise that we won’t lose clients’ money because we can’t do that. But we are downside aware. It means that there has to be compelling valuations really for us to be involved.

CS: And I’m sort of going to just weave a couple of questions on the back of that. So top down with the macro awareness, couple with the sort of bottom up of stock selection and then also how that downside aware feeds into the past 12 to 18 months, which have been a very interesting time for markets. Maybe just talk about how that top down bottom up sort of works and then in tandem with what the last 18 months has looked like as an in the economy.

SE: Yeah, sure. And both the top down and the bottom up a are important, but we always start with the top down because it helps inform us what type of interest rate exposure we want in the fund. So that’s known as the duration exposure of the fund, where we want that interest rate exposure to be, whether it’s in the UK, whether it’s in the US, whether it’s in the Eurozone, for example. And how much risk we want to take outside of interest rate exposure. So that’s typically credit exposure, you know, what are valuations looking like in corporate bond markets? What is our macro view of the world? Is it an environment where we should be taking more credit risk? And that might depend or it will depend on the economic data. It’ll also depend on our view on what we think central banks are going to do.

So, you know, that’s always the starting point is the big sort of macro picture, and it’s always evolving, right? It never stands still, as we know over the last couple of years at times the focus has been very much on inflation. Other times the focus has been on growth, and this is a constantly sort of moving environment. So that’s the starting point trying to get a handle on this big picture view of the world.

But equally the bottom up approach is very important. We have a team of highly qualified corporate bonds, credit analysts that cover different sectors. So they’ll give their views on where they’re seeing value and where they’re seeing risks. And they themselves will drill down to, you know, individual opportunities as well. So they’ll look at you know, when company results come out, they’ll look at the company results and opinion on whether there’s value and if we hold the bonds, whether there’s a risk to continuing to do so. So the bottom up analysis is extremely in important as well.

And I’d say that extends to emerging markets because emerging markets is often sort of people sort of consider it one big sort of sort of opportunity set, but you know, in reality there’s a lot going on underneath the surface as well, if you can imagine with all the different monetary policy cycles in emerging markets, et cetera. So we have a we have extensive resources throughout Invesco, and we have an excellent strategist who sits within our team where we’re based in Henley who looks at these opportunities in the emerging market space. So the bottom up is very important there as well.

CS: Okay. I wanted to talk a little bit about the UK and maybe we can broaden it out beyond that, but obviously we’ve had a couple of rate cuts last year. We’ve seen one already this year. What sort of impact are you expecting this to have, you know, on the portfolio in terms of your outlook and what you expecting going into 2025? I mean, spreads are tight, you know, how do you expect there to be significant changes or are you sort of very much in the risk averse camp at the moment?

SE: Oh, look, the UK is a fascinating space from a macroeconomic perspective. I’m sure all your clients are following it closely and particularly the interaction between monetary policy and fiscal policy and inflation and growth risks. So, you know, it’s quite a complex picture, but it’s one that has given us a lot of opportunities over the last couple of years because it’s been very volatile where at times the markets have not priced much in the way of interest rate cuts in. And, you know, we take an issue with that. We’ve thought that there should be more and equally you know, the pendulum can swing the other way as well, where there are too many cuts priced in. So, you know,, it is quite a volatile space and we try to be quite active when it comes to our UK interest rates exposure for that very reason.

Coming back to your question you know, I always get asked what I think you know, I’m always a bit reluctant to make predictions, but you know, for us it’s all about where the risks lie relative to what is priced in. So we came into the start of this year believing that with only two, I think it was two further interest rate cuts priced for 2025, that that wasn’t enough given the potential downside growth risks particularly in the labor market, which, you know, we are seeing signs of some weakening there. So, you know, it was quite an easy decision to take our UK interest rates exposure a bit for that reason. And since then, as you said, we’ve had another rate cut and now we’re in a position where I think there’s somewhere between two and three further cuts price for this year, which I think is reasonable. You know, if you were to hold me to a central view, I’d say that that’s about right. But I would probably still say that the risks around that are asymmetric and that if these downside growth risks do continue to materialise, then ultimately the Bank of England will have to cut more aggressively at some point towards, particularly towards the back end of this year and into next year.

CS: And just quickly, you mentioned the opportunities. Where are you seeing the opportunities in the UK? Are they across the market? Are they in certain sectors?

SE: Well you know, we’ve seen some good opportunities in some of the better quality corporate bonds at the short end in particular. So at times when the market has moved to price in not many rate cuts in the UK, so in other words, and at times actually over the last two years have priced in more rate hikes. I mean, obviously the Bank of England has been cutting rates over the last sort of six months or so, but prior to that, there were times when there were just too many rate hikes priced into the UK and that allowed us to take advantage by looking for some decent issuers issuing in sterling and picking up some decent yields in the front end. We do still like the banks for the most part we think financials are still in a good place. Balance sheets are pretty strong banks of well catalysed although one could argue there are downside economic growth risks you know, the banks are more than equipped to, you know, deal with that. I wouldn’t say it’s those downside risks and material enough to, at least for now you know, impact valuations there. So we still, like the banks, we still hold bank capital, particularly in shorter data maturities because you get some nice attractive yields, the likes of Barclays, for example, where you know, we expect Barclays to what’s called just a bit of a technical term, but call those bonds and effectively redeem them so you can get a nice short term yield in some of those issues.

CS: I didn’t wanna spend too long on inflation. It’s been a bit sticky in the UK and there’s talk of it going up again. Maybe just, do you make any preemptive calls on inflation as well, and does that impact the portfolio, again, with that risk averse hat on? Just give us a bit of a line on that so we can see where you stand on that, please.

SE: Yeah, we’re, you know, we’re not really in the business of forecasting inflation. We’ll let others make those mistakes <laugh>, but we are in the business of you know, making an assessment and a judgment on where the risks lie and looking at the underlying trends in inflation. And that’s not just that the headline or a core level, but also the key components as well.

So inflation is expected to pick up once again, in the UK, clearly nowhere near the levels that it did. I think it was back in October 2022 when it peaked at around 11%. I think I have that year, right. You know, it’s some significantly way below there now. But there are certain factors that causing it to increase once again energy prices food prices.

I think utility prices, VAT on school fees, for example. We’ve got the policy measures from the recent budgets, the increase in employers, national insurance contributions. There’s some uncertainty about how and whether businesses can pass that on. And also the increase in the national minimum wage as well. So, you know, there’s various factors that are causing this likely bump in inflation into the spring and beyond. But the key point I would make is the Bank of England know this, it’s in their forecast, in their projections.

So actually one of the interesting outcomes from the most recent Bank of England meeting is that they made a judgment on the supply side of the economy which in their opinion means that inflation could sort of stay a little bit stickier for a bit longer. So it’s in their forecast. So we have to make a judgment of where the risks around those forecasts lie. And I think we take the view that once these downside growth risks that I alluded to materialise as we sort of progress through this year, and particularly if the labour market unfortunately weakens, then ultimately that will, you know, keep lids or should keep a lid on inflation in the medium to longer term.

CS: I wanted to sort of ask, you’ve talked about inflation, I just wanna sort of focus on the other side of the pond. We’ve got a new Trump 2.0 is kicking into full gear. Obviously the US has been very resilient, recession resilient, as as may be. Obviously a lot of his policies are very inflationary. Do you see that strength continuing? Does that come into a macro forecast? May maybe just cast an eye on the US for us and how you play that at the moment in the portfolio?

SE: Yeah, sure. I mean, look as I’m sure most of your clients would know, the US is all important when it comes to the direction of the global fixed income market. So we spend a lot of time you know, really digging into the weeds when it comes to the US economy. And look, it’s true. I mean, if you go back to 2022, 2023, there was a very, very strong consensus that the US would go into recession because of the aggressive rate hikes that we had over that period. And, it just didn’t materialise. And I think there are several reasons for that.

I’m not gonna go into extensive detail, but there was strong fiscal support and stimulus in the sort of covid and the post-covid world that partly bolstered consumer savings, right? So that helped the consumer services demand remained very strong post-covid, everyone wanted to travel. I think more recently the fall in inflation has boosted real incomes as well. And of course we’ve had the Trump election as you’ve mentioned, and half the country is very happy, you think, and perhaps half the country a little bit less so. But as is often the case after US presidential elections, you often do get a bit of a bump in the growth data. And I think in some of the sentiment indicators that we look at that that is certainly true.

As for what happens through this this year look, I mean there are some factors that I think quite obviously or should support US growth, deregulation being one of them. Also Trump has stated that he wants to extend the tax cuts from 2017, that should be supported. But there are other things that work in the opposite direction as well. You know, everybody’s, I guess following the you know, this ‘Doge’ department that’s cutting government expenditure I mean if that is proves to be comprehensive and extensive, then you’d think that would have an impact. The curbs on immigration, I mean I think there’s been something like seven to 10 million immigrants over recent years. I don’t know the exact numbers, but that’s boosted the US economy particularly household consumption, you’d think that if that at least stabilised, if not went into reverse, then that could be a negative. And also tariffs you know, ultimately that’s a tax on consumers. So if the pool sort of threat or promises on tariffs are implemented, then that could ultimately quite be quite punitive as as well.

So we just have to see, I think we are getting a bit of what I term as a Trump bump at the moment. But I think over coming months things should become a bit clearer. The only other thing I would say is that the US labour market, I mean, it has improved a bit over recent months, but it has been on a moderating trend over the past sort of 12 to 18 months. Which, you know, is something that we are monitoring very closely. What we haven’t yet got is active layoffs but the hiring rate in the US is moderating for sure. So that is definitely something to watch and that we’re certainly keeping an eye on.

CS: Just quickly because we’ve been sort of dancing around geographies, you also have a small allocation to emerging markets. Could you just talk me through that and are there any fundamental differences in what you look for in an emerging market bond versus the developed market?

SE: Yeah I mean, you know, as I said earlier, the emerging markets, that’s a broad church. There’s a lot going on there. There’s certain central banks that are far more conservative and prone to hiking interest rates more aggressively in order to fend off inflation pressures and ultimately protect their currencies. Others less so.

So for example, Mexico has been quite aggressive that hiking rates in recent years as has Brazil. On the other hand, Turkey hasn’t. So there’s, you know, quite some contrast there. So we are looking for I guess at, in local in terms of local bonds. We’re looking for central banks that have a hawkish lean in. Now ordinarily your clients might think, well, surely that weighs against fixed income, but it’s about getting…what it amounts to is, if these central banks are hawkish, then ultimately that’s going to print down on inflation and economic growth. And then that means that at some point you can see good value in some of these local bond markets.

So we’re seeing some very attractive yields, for example, in local Mexican and local Brazilian debts at the moment. Because these central banks have been quite aggressive at hiking interest rates. You know, there’s other things that go on as well. You have to watch the fiscal side of things as well, I think in emerging markets versus developed markets. Though perhaps we could say the UK was a good example where this is not true, but certainly in emerging markets you know, if the authorities have not got control over the public finances, then you know, investors it’s a higher hurdle for investors to have confidence you know, in these markets.

But this as I said, the same is true for developed markets as well. We’ve seen recently how there was a bit of a wobble in the UK gilt market because of concerns about public finances. So I don’t think it’s just confined to emerging markets anymore, but certainly we look at the public finances in great detail as well.

CS: I wanted to touch quickly on duration. In your case, the duration of the fund is a lot higher than it was a couple of years ago. Maybe just start by explaining to the listener what duration is, and then just talk to me through, is your duration a higher from a very low level, maybe just give us an idea of where it is in the grand scheme of things at the moment.

SE: Yeah, sure. So duration is a measure of the interest rate sensitivity or the price funds sensitivity to changes in interest rates, at the fund level. And then obviously when it comes to individual bonds the same theory applies. So we can adjust the interest rate sensitivity of the funds, we can adjust the duration of the funds. And what I would say about that is structurally the duration of our funds is significantly higher than it was two to three years ago, but two to three years ago, bond yields were not much above zero in that sort of zero low interest rate world, there was just no valuation in bond markets. So for us, it made it quite difficult to take duration up. The risks seemed very, very asymmetric as you could imagine.

So if you go back to late 2022, we had the duration in the funds very close to zero. Now it’s significantly higher than that because bond yields are, government bond yields at least are looking a lot more, you know, compelling in our view. Now that said and as I sort of made the point earlier, the macro environment is very, very, very volatile when you’ve got this tug of war going on between inflation and growth. So we still think it’s an environment where you should be very flexible and nimble with your duration, with your interest rates allocation because these bond markets are still very, very volatile.

You know, we’ve seen some quite big yield swings over recent years, and I think that will probably continue. So I think it’s prudent for us to not get wedded to a really high duration view. I think it’s important that we are pragmatic and we’re constantly looking at the fundamentals, but more importantly, in the context of the valuations on offer as well. So yeah, we make no apologies, we are very flexible with our duration allocation. It’s never perfect, butI think we’ve done a reasonable job over the past couple of years at managing.

CS: And just lastly, maybe to sort of knit it all together, we’ve talked a lot about the macro and you’ve mentioned that things are volatile to say the least. We’ve got government bonds over here that are sort of offering a fair return and the spreads are perhaps not as attractive as they have been, but that doesn’t mean they’re totally unattractive. Maybe just talk to me, I mean, in terms of the position of the portfolio. Do you feel that there’s a lot of opportunity out there, there’s a lot of dispersion to find, you know, good, attractive, attractive opportunities for the portfolio, and how helpful is that flexibility and sort of bringing that out?

SE: Yeah yeah, so I mean, it is a great question. We mean there’s always opportunities in these bond markets. We’re seeing a little bit more differentiation between the between the central bank cycles and the macro fundamentals in different countries and regions. So that’s given us an opportunity. We’re quite flexible, not just in terms of our overall duration allocation, but also as I think I mentioned between different countries and regions as well, right? So we look at country spreads, for example. So that gives us some opportunities. And emerging markets we’ve obviously touched on, there’s some good diversification opportunities really good yielding opportunities there also in terms of our allocation between government bonds and corporate bonds what I would say is we still have a decent allocation to corporate credit. It’s just significantly lower than where it was several years ago. And there’s good reason for that.

Credit spreads difference between corporate bond yields and government bond nuance in our opinion are quite narrow. So we’re not getting that sort of, you know, relative valuation advantage. We don’t see a compelling reason to take more risk and invest in the corporate bonds space when you’re getting perfectly attractive deals in government bonds. And there are, you know, potentially downside growth risks as well that could emerge over the next 12 to 18 months. We’ve touched on the new US administration. We’ve touched on what’s going on in the UK. We haven’t really spoken about Europe, but Europe really is at the epicentre of Trump trade wars particularly if it goes after the auto sector, which is important to Germany. So, you know, there’s lots of reasons to think that you know, growth risks are over the foreseeable future.

Perhaps skewed a little bit towards the downside which would, you know, for us tend to favour government bond exposures over corporate bond exposures, particularly when the valuations in corporate bond markets are not that compelling.

So that’s where we sit at the moment. We’re a little bit more defensive on the credit side than we were a couple of years ago, but we’ve got a little bit more duration or quite a bit more duration actually, than we did have two years ago. But we are being very flexible and very nimble with that.

CS: Stuart, on that note, thank you very much for joining us today on the podcast.

SE: Absolute pleasure.

SW: As we’ve heard today, the Invesco Tactical Bond fund is the most flexible fund in Invesco’s fixed income range. This means the team can make the most of all the opportunities presented across the market. To learn more about the Invesco Tactical Bond fund visit fundcalibre.com – and don’t forget to subscribe to the Investing on the go podcast, available wherever you get your podcasts.