A different ball game

Fixed income has never been the exciting asset class, but its defensive characteristics have made it the Dennis Rodman (two-time National Basketball Association defensive player of the year) of portfolios, compared to equities that build the basis of your offense, like Michael Jordan and Scottie Pippen.

Some days your scorers will struggle and it helps to rely on your defensive pieces to keep you in the game, like Rodman often did for the Chicago Bulls.

Which brings us to March, the toughest sell-off since the late 1980s (before Rodman had even won his first defensive player of the year award) – this was the time for fixed income to show its defensive sturdiness, and it did, but coming out from the rebound was a different ball game.

But as portfolio managers try to reconfigure their starting line-up, they have had to weigh up the risk of more market volatility and either go for more defensive protection with fixed income or take more chances and aim to score more points with equities.

Either way, it’s no easy slam dunk.

Gopi Karunakaren, Ardea portfolio manager, said, to put it bluntly, the argument for conventional fixed income right now was pretty weak.

“If you think about the way conventional fixed income works and the role it’s supposed to play in a broader multi-asset portfolio, the very low-rate/low-yield environment we’re currently in makes it very challenging for conventional fixed income investments to deliver to those expectations,” Karunakaren said.

“If you think about why people have fixed income in a portfolio, it’s usually some combination of wanting a stable source of income and diversification against equity risk.

“The way that conventional bonds work is that yield for that interest income you’re getting from those bonds is really the primary driver of being able to meet those expectations for fixed income.

“Problem is yield, in most places, is extraordinarily low – near zero if you look at government bonds, for example.”

Darryl Trunnel, Principal Global Investors portfolio manager, said fixed income was still an attractive option as there were concerns for company earnings in equities.

“As you look at the global economy, there’s a lot of uncertainty on the heels of the COVID-19 pandemic and how long it will take for economic activity to return to the levels it was before,” Trunnel said.

“The risk/reward may not be what it once was, so as you look at fixed income markets around the world, although yields are low, there’s some attractive opportunities to earn some income and to have an enhanced risk profile if you diversify into fixed income.”

Trunnel said many equities had rallied back since the middle of March to levels that suggested earnings were not going to be lessened, but that would not be the case.

“January to March only had one month of a downturn factored into them, there will be more of that reflected in the upcoming earnings that are going to get started in July,” Trunnel said. “I think right now, ahead of that would be an opportunity to switch more into fixed income.”

Erik Keller, Robeco client portfolio manager global credits, echoed the sentiment that although equities had recovered strongly, earnings were still going to be under pressure.

“Those earnings were already weakening going into 2020 [pre-COVID], but with the recession you will see a strong earnings decline,” Keller said.

“It doesn’t bode well for a lot of equities in Australia because markets have priced in quite an optimistic scenario.”

Nathan Sheets, chief economist at PGIM Fixed Income, said the appropriateness of an increased allocation to fixed income was still dependent on the investment horizon or risk appetite.

“We are living in a world of sustained low inflation and that was true before the virus,” Sheets said.

“Low inflation reflects ageing demographics, rising debt levels, restrained inflation expectations as a result of slow growth.

“All of those things are going to be very much with us and that’s going to translate into a lower trajectory of rates going forward.”

RECOVERY

Analysts have been debating whether the economic recovery would be V-shaped or U-shaped, the former being a faster recovery, while the latter being a drawn-out process.

Trunnel said a lot of equities had already seen a V-shaped recovery, but the actual economy itself would not be a ‘V’ at all.

“It’ll be a long drawn out ‘U’, getting back to the levels before COVID-19 will take at least through to end of next year, if not longer,” Trunnel said.

Jay Sivapalan, Janus Henderson head of Australian fixed interest and one of the inaugural Money Management Alpha Managers, said the firm had a pragmatic and realistic view of how the economic recovery would occur, which would be a U-shaped recovery – but that this was one of the more generous ways to describe the economic recovery.

“Essentially, we expect 2019 year and economic gross domestic product [GDP] levels to be restored by the end of 2021, essentially two years of lost growth,” he said.

“The way the economy entered this crisis it will emerge from in a softer place – higher levels of unemployment [and] we still have a corporate and a small-to-medium enterprise [SME] default cycle to go through – so we’ll emerge from it from a softer place.

“That said, clearly policies are clearly working very strongly to get everyone across to the other side.”

In Sheets’ perception of a U-shaped recovery, he also expected it to take to 2021 to get back to the Q4 2019 level of GDP.

“Could it be better than that? Absolutely, I’d say that is possible and that’s where you get into the classes of V-shaped recoveries,” Sheets said.

“But it could also be worse, struggling with full-blown second waves of the virus.”

Keller said a potential second wave of the virus would impact the shape of the recovery and most likely delay it.

“Aside from the risk of a second wave or a long first wave like we’re seeing in the US, there’s also the US elections that will create additional volatility, and tensions between US and China,” Keller said.

“There’s a lot of additional risks that could result in a more cautious prediction here, so we don’t really see a V-shaped recovery.

“The optimistic scenario is that we will get this recovery by the end of 2021, back to pre-COVID prices.”

INTERESTING (RATES)

Karunakaren said the combination of the economic disruptions that were created by the virus, led to central banks stepping in very aggressively to stimulate economies by cutting interest rates to very low levels.

“In a V-shaped strong economic recovery scenario you could see a bit of upward pressure on rates,” Karunakaren said.

“But probably not a lot because the system and economy is too fragile to handle a very big increase in interest rates.

“The only scenario in which it’s likely you could see a V-shaped recovery lead to significantly higher interest rates is if inflation makes a comeback.”

However, if inflation did not make a comeback, there was not a huge amount of pressure on central banks to start hiking rates.

“Knowing how fragile the system is and how fragile economies are right now, they’re probably not going to be in a big rush,” Karunakaren said.

“If we have a much weaker scenario, what is clear to us is that monetary policy is exhausted already.”

“Rates are already at zero or close to, central banks are already flooding the markets with liquidity and they’re buying lots of bonds through the quantitative easing (QE) program.”

Because monetary policy had been the dominant form of stimulus for the past decade, it had been exhausted as an option.

“If we get more severe prolonged weakness, it means that fiscal policy needs to step up,” Karunakaren said.

“That means much more Government spending on top of what’s been announced and what we’ve already seen, and much more government issuance coming to the market.”
Sheets said he expected the low rate environment to be the reality of the next decade, at the very least.

“Consistent with that, we’ll also see credit spreads over the medium to long run grind tighter,” Sheets said.

“That can be across the board in various kinds of corporate bonds, structured products and certainly for investors with medium to long term horizons in emerging market debt.”

Sivapalan said the work the Reserve Bank of Australia (RBA) had done was to ensure normal market function and to provide liquidity, but other actions could be used to stimulate the economy.

“They haven’t really stepped in, in terms of stimulating the economy, and in the last 90 days if they had unveiled programs to stimulate the economy it may not have worked because we’re all locked down so we couldn’t exactly go out and spend money,” Sivapalan said.

Although the Australian Government had introduced JobKeeper and improved JobSeeker, Sivapalan expected future actions like the US Federal Reserve had recently done, which included direct support to SMEs and households. 

“There will be some other programs unveiled to support banks, the SME sector, which is a bit different to the Global Financial Crisis (GFC) where the support went to Wall Street and not enough to Main Street,” Sivapalan said.

“This time around I think the lessons have been learned and they recognise that if you want to get unemployment down, you need to support SMEs.”