Higher volatility and fixed income positioning

Funds Management

by Clive Tompkins

Antares Fixed Income manager Dr Tano Pelosi talks with Ross Kent, Global Head of Institutional Distribution, NAB Asset Management about increasing bouts of volatility that are requiring a move to shorter duration, higher quality bonds.

Ross Kent: Hello my name is Ross Kent; I’m the Head of the Institutional Client Group at NAB Asset Management. And joining me this afternoon is Dr Tano Pelosi from the Antares Fixed Income team. Welcome Tano.

Dr Tano Pelosi: Thank you Ross.

Ross Kent: We spoke probably six months ago and at the time, you were foreshadowing a fairly bumpy ride through 2018. Looking through the lens of the year to date, how’s it going?

Dr Tano Pelosi: As you say, pretty much as we expected. So we’re seeing an increase in the balance of volatility. But not only that, the volatility is actually becoming more pronounced, more magnified. And there’re several reasons for that, which we can go through this afternoon. But one of the key ones is that we’re seeing a tightening in financial conditions, as a result of withdrawal of central bank liquidity.

Ross Kent: This reference to liquidity, we hear about it a lot, it’s referred to a lot. In really practical terms, what are the biggest changes? For example, when you’re thinking about setting the portfolios to be more resilient, without liquidity.

Dr Tano Pelosi: The biggest change over the last few years has been quantitative easing. So you think about all the accommodation central banks have provided, not only by lowering official interest rates, it got to the zero bound and they had to do a lot more to solve the problems, in the economies worldwide. And what that effectively meant was they had to essentially grow the size of their balance sheets, by buying assets, predominantly bonds. It’s happened across most jurisdictions. And what happens effectively is as they buy the bonds; they’re driving the risk-free rate down and at the same time, driving risk premiums lower. So essentially, it’s a liquidity effect that’s driving our asset valuations. It’s been one of the predominant drivers of asset valuations, over the last 10 years.

Ross Kent: I imagine as a result of that, if you like that liquidity tailwind being withdrawn somewhat. Perhaps portfolios that have been more reliant on the carry trade, might be a little more exposed at the moment?

Dr Tano Pelosi: That is true, mainly because firstly you’ll see an increase in volatility and that challenges the goldilocks inspired carry trades, if you will. But also because where we are in the cycle, so arguably the US is now in a late cycle. Therefore, the trade-offs between growth and inflation become a little bit more pronounced, which gives central banks like The Fed and to that extent, the ECB I would add, less scope to pull back on stimulus - withdrawal of stimulus, or what we call quantitative tightening. And that was really the story of the last few years. Every time there was a hiccup in financial markets, essentially the central banks had your back by walking back great expectations, by essentially providing more accommodation. They have less scope to do that going forward.

Ross Kent: From the portfolio management perspective. What are the considerations that are uppermost in your mind?

Dr Tano Pelosi: What we now have is a situation that becomes a little more binary. As I say, it’s certainly not goldilocks anymore in our view. You have increasing bouts of volatility; you have these trade-offs between growth and inflation. And so inflation risks are percolating upwards, which of course has broader ramifications for risk assets, including credit. And at the same time, I think what we’re seeing is the rise of geopolitical risks. Call it trade wars, emerging market crises, what’s going on with North Korea and the US.

So these now become, they come really to the fore, in a way they haven’t in the past, because of essentially that central bank put that was in place. The central bank put is no longer there now in our view, therefore, the markets are left very much to their own devices. So what does that argue for from a portfolio stand point? It argues for thinking more about liquidity, diversification and taking out cost effective hedges where it makes sense.

Ross Kent: Just on that point around hedging, you’ve made reference to the potentially enlarged inflation risks. In your own mind, where are perhaps the opportunities to enhance portfolios with some inflation protection?

Dr Tano Pelosi: Yes I wouldn’t rule out co-trades altogether, I think they still have a role to play, it becomes synonymous with credit risk. So we would still look to take good quality credit risk, in as liquid a form as we can. But we’d also think about taking out some sort of inflation protection, where portfolios can do that. Particularly given that inflation risks these days tend to be more global in nature. So if you wanted to continue to participate in the credit story and I think there’re still good reasons to do that, particularly in the shorter end of curve, so short duration credit. But also coupled with some protection from real rates, essentially it’s a soft long we think of in those terms.

So you’re taking out protection through longer duration in real assets that will give you some cover, if there was an inflation surprise, which clearly would in our view have some negative spill over effects, for credit and other risk assets. So this is the sort of hedging we’re talking about.

Ross Kent: Tano as ever, a very lucid explanation of the portfolio conditions we’re facing at the moment. I wish you good luck for the balance of this year and thanks again for joining us this afternoon.

Dr Tano Pelosi: Thank you Ross, it was my pleasure.