Roundtable: Finding our place in the credit cycle

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16/07/2018

There’s a view among economic experts that current low interest rates will rise and higher rates on high global debt levels will eventually lead to a recession.

Additionally, less liquidity in the market and the ‘late cycle’ environment are making many investors cautious, says the chief strategist at the $717 billion US-based investment management firm PGIM, Robert Tipp.

Tipp spoke at a recent Investment Magazine roundtable on ‘where we are in the credit cycle’ and noted that investors are still anxious about the so-called “spread sectors” in the bond market – corporate bonds, structured products and emerging market debt, which offer higher yields than safer government bonds.

This caution may result in investors leaving money on the table if it turns out to be a longer credit cycle, Tipp said.

“The general impression I get from investors is that there’s anxiety,” Tipp said. “We’re nearly a decade into the expansion, the Fed is raising rates and spreads are tighter than average. Therefore, it warrants a cautious approach on the credit side. “I don’t think this cycle is different, just the length.”

Tipp said there aren’t yet the seeds of a hard downturn, thanks to tighter regulations and the cautious approach central banks are taking as they move from quantitative easing to tightening.

PGIM’s general view was that with the best part of the bull market over, long-term rates should be low and within a tight range.

“The world has been on an ageing demographic trend for decades and the effects of that may have been masked by the rapid extension of debt,” Tipp said. “So now that the debt cycle has maxed out, we’re left with an environment of very high debt levels, which may have lowered the equilibrium level of interest rates.

“I can’t say we’re not going to go to 3.25 or 3.5 per cent on the 10-year [Treasury] note yield but I think it’s more likely the sell-off stops around current levels. Eventually, we may find out that the new equilibrium level for 10-year Treasuries is actually even below 3 per cent.”

Timing and opportunity

Despite the possibility of a recession down the road, Tipp said it continues to look like a pretty solid environment for investing overall.

“The price-earnings multiples might look a bit elevated at first glance, but not if we remain in an environment of low long-term rates,” he said. “In that case, these multinational companies that dominate the major indices look reasonable, which also bodes well for the credit markets in fixed income.”

However, high debt levels across the world remain a cause for concern, head of multi-asset income at Morningstar Investment Management, Brad Bugg, said. Morningstar manages about $200 billion worth of assets globally, with about $10 billion across Australian institutional and retail clients.

“We don’t think the world can afford rates of 3.5 per cent to 4 per cent,” Bugg said. “Volumes of debt in the world today act as a natural ceiling for where they can go. If you’re worried about rising rates, are you going to be stepping back into the market? We think there’ll be some volatility around this dynamic as it plays out and that could potentially create some opportunities.”

Bugg said he thought markets were still pretty expensive, whether for bonds, credit or equities, and that opportunities could come from higher volatility; however, he was also concerned about the impact of unwinding quantitative easing, especially in Europe.

PGIM head of institutional relationship group, Australia and New Zealand, Cameron Sinclair, said investors seemed to be more concerned about the maturing credit cycle and were either rotating into parts of the credit market where they saw better relative value and pricing or looking for investment managers to be more active in sector rotation.

Sinclair was concerned that the consensus view of a longer-term economic downturn might reflect a level of complacency around near-term economic strength globally. That said, he sees evidence of a shifting mentality in the way investors are reorienting their investment strategies, increasingly looking towards unconstrained mandates as a way of navigating the credit space and building more resilience and downside protection mechanisms into portfolios.

“Investors are looking for absolute or total return-style investments,” Sinclair said. “That’s probably a sign that people are becoming a little more cautious.”

It’s important for asset owners to work out the timing of the next recession, said managing director and senior portfolio manager at Russell Investments, Andrew Sneddon, who is part of a team that invests $15 billion in assets for Asia-Pacific clients.

He’s not sure Australia can avoid a recession. “I think the consensus is that it’ll be a 2020 event, which means, from a market pricing perspective, we’ll probably think about it more acutely towards the end of the year,” Sneddon said. “I think the timing of the recession is the anchor point around a lot of these [market] questions.”

Given this, Sneddon said there were some opportunities in loans and other parts of the market with high beta (high volatility), such as emerging markets and local currency debt.

“They offer an interesting journey, albeit a high-volatility one,” he said. The general view at Mercer Investment Consulting was similar, Mercer principal Chris Baker said. He noted that corporate leverage had ticked up, economic fundamentals looked strong in the US and the shift from quantitative easing to tightening had changed the flow of money to credit.

“We don’t see a crash that’s imminent but we’re certainly conscious of it over the short to medium term,” Baker said. “On the credit side, we recommend clients don’t allocate to single sectors but employ a multi-asset approach in a benchmark unaware fashion instead.”

Senior investment manager at Colonial First State Investments, George Lin, agreed with Tipp’s view that there won’t be a sharp rise in bond yields. “We talk to a lot of credit market managers and they say the fundamentals of credit sectors are reasonably OK,” Lin explained.

“I think what Robert [Tipp] has outlined is a pretty plausible base-case scenario; with rates slowly rising, the credit spread may widen a bit and may tighten a bit, but won’t move much. I don’t think interest rates will go up, but say they do, what’s the number? I don’t think it’s as low as three or four.”

Staying ahead of the curve

One of the headaches for institutional investors right now was finding an allocation that’s not too expensive, chief investment officer of the $5.5 billion EISS Super, Ross Etherington said. He pointed to the importance of diversification and the growing attractiveness of alternatives as a result.

“I’m thinking of investments that aren’t correlated to equities, where you might get something like 6 to 8 per cent in theory, with reasonable volatility,” Etherington said. “We use different levers like yield curves and currencies to add alpha in this low-return environment.”

He agreed it was late in the credit cycle and asked what was going to stop inflation from ticking up in the next 12 months. Tipp responded: “Global competition in the goods and labour markets.”

He was more concerned about the eventual long-term downside, warning that when the next recession arrived it would be difficult to revive economies.

“In the next major downturn, central banks will end up cutting rates to zero and maybe moving into QE,” Tipp said. “If markets begin to price in that part of the probability spectrum, yield curves may end up looking more like the 19th century.

Back then, some developed market yield curves were inverted. Bond investors – or pensioners – were probably more concerned about locking in their annuity than pushing for potentially higher yields.

For now, there are still opportunities for good investment and, as such, Escala Partners is looking at high-quality investment-grade debt, Escala investment adviser Ed Brooke said.

The firm advises wealthy families, high-net-worth individuals, foundations and charities on investments, and has about $1.1 billion under advisement.

“We think we are late cycle, in that bond yields will rise, probably more in line with just a gradual increase,” Brooke said.

“So, to keep volatility low, we’re avoiding the duration play. But we think you’ll get an increase in volatility in credit spreads and that’s actually not a bad environment to be in, because you can move your portfolios around.

“For example, in January, when credit spreads tightened, we were positioning portfolios in very high-quality bonds. Now that we’ve had a spread widening, we think we get something extra by going into capital structure and the risk isn’t high at the moment.

“Now that we’ve had a spread widening, we think we get something extra by going into capital structure and the risk isn’t high at the moment. Economies are still going reasonably well, so that’s not a bad place to generate some extra yield. The other thing we’re looking at is market mutual funds and areas where volatility is a little bit more contained,” Brooke continued.

“What we’re seeing in the last two months is that a number of new funds opening up to private debt, with the banks stepping away, has alarm bells ringing. It’s not too bad [but it seems] a lot of new products are opening up.”

PGIM’s Tipp said many investment problems come from investors’ behavioural finance pitfalls.

“We want to think if we can just solve certain problems, we’re going to make money,” he said. “Right now, I think the misplaced focus may be on inflation and the central banks removing liquidity, and rate hikes leading to higher long-term rates.

“What investors may be missing is the bond market’s supply side. Even if price and wage inflation are a little higher and short-term rates are higher, long rates will ultimately be driven by the supply and demand for money.” Demand for credit has been decelerating in the US, Tipp said.

This suggests interest rates are not at a level low enough to encourage investors to borrow. He concluded that with long-term interest rates within tight ranges and a moderate ongoing economic expansion, there should continue to be a good backdrop for adding value in credit sectors.

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