Owen Murfin, an Investment Officer and Institutional Portfolio Manager with MFS Investment Management has been in Australia this week and caught up in Brisbane with FINA’s Brenton Gibbs for a conversation about their market views, expectations, portfolio allocations, and some opportunities.
Brenton: We’ve recently seen rising geopolitical tensions. Do you think that yields are fully reflecting the risk at the moment?
Owen: What happened in Israel is a reminder that geopolitical risk is a constant theme. We’ve also got the Iranian situation, and the Chinese threat to Taiwan.
Holding duration can be advantageous with yields at these extremes at the moment, it only takes a certain geopolitical risk to overflow and we could see a nice rally.
Oil prices have peaked, and came down very quickly, so it appears the conflict is quite contained at the moment just to the Gaza Strip. But geopolitical risk isn’t dominating the bond market at the moment, it’s more the inflation story, and that’s really what’s driven bonds the last two weeks in particular.
So, the pricing of that risk could still fluctuate fairly quickly?
Owen: Exactly. And I think that geopolitical risk is very unpredictable. We know what the sources could be or whether they blow over. Like if the Chinese decide to invade Taiwan, then obviously that would be a massive bull case for the bond market, we’d probably say. But it’s just so hard to position yourself for that because it’s such an uncertain outcome.
Yes, could you talk a little about China and its economy, and its global influence?
Owen: Well, China is one of the big growth engines. So, it is concerning what’s happening not just in China, but in Europe. People tend to obsess about US growth, which has been pretty healthy, but the rest of the world has been pretty weak. China has a lot of big challenges over the next year, consumer confidence is very low. On the fiscal side, local government debt is still very high, and the amount they’re receiving from land receipts is going down as real estate markets have taken a pummeling as well.
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So, there’s just a lot of concerns generally about Chinese growth. The Chinese authorities are in bit of a straightjacket because when US interest rates are this high, it’s very hard for them to cut interest rates, as it would probably lead to a weaker currency when US dollar rates are so high. And also, fiscally, they can’t do too much because they’re trying to remedy the debt rather than add more debt to the system going forward.
So, I think the Chinese authorities are a little bit more constrained than people might think in terms of their ability to stimulate the economy. So, we’re pretty negative. We’re mostly reflecting that through being short the currency, so the CNY. The thing about bonds is they’ve already done incredibly well to reflect that kind of pessimistic view that the markets have. So, Chinese bonds have gone from trading in cheap to treasuries to now actually trading way through treasuries. So, the better way to express our view is typically through the currency.
So, fair to say, you’ve got a fairly active China watch?
Owen: Yes, exactly. And you need to, because it’s such a big engine of growth accounts for about 17% of global GDP. What happens in China is very important, not just locally, but generally, to inflation worldwide. If China is deflating, the rest of the world tends to deflate as well. China helped the world out of growth problems – 2008, 2015. The difference then was it had more room to fiscally expand its economy. Now, it’s not so much about wanting to support growth, it’s more about financial prudence. So, there’s quite a big change of emphasis.
Turning to the US and interest rates, what are your projections for US interest rates over the next 12 months? And do you, in fact, think that the Fed will start easing rates soon?
Owen: Well, certainly, after the rally we’ve had in the last two weeks, the markets are now prepared for rate cuts as early as May and probably at least three cuts by the Fed next year. We are in the camp that that sounds reasonable because we’re thinking more about a recessionary, hard-landing type scenario. So, we’re not disagreeing with the markets, albeit it’s reasonably well priced in.
But there are some headwinds such as geopolitical uncertainty and refinancing risk due in the corporate market in the next two years. Can companies access capital to refinance maturing debt that they enjoyed in the last five years is a big question. So, private credit, and lower quality public high yield markets, could trigger wider spreads.
Now, that’s when the Fed might have to come in more aggressively and potentially cut more than what the market expects. But as a baseline scenario, we think two to three cuts is very feasible in the US for the next 12 months.
Does MFS’s base cases for recession include Australia?
Owen: No, I wouldn’t include Australia necessarily. It’s a lot of harder to think about what the rate trajectory would be in Australia relative to other countries.
If we’re looking to take duration risk, it tends to be in countries like New Zealand, where tightening has been more aggressive and monetary conditions are that much more restrictive. New Zealand is also slightly more leveraged and there’s significant inflation in the real estate markets as well.
So, I think, in Australia, there is probably more to do in terms of monetary tightening. Inflation numbers are not as encouraging as they are in the rest of the world, so it’s hard to really extend these rate cuts into Australia. There’s no rate cuts priced for Australia next year either. So, again, the market is taking the same view that Australia’s going to be slower coming to lower rates than the rest of the world.
Moving on to your current portfolio allocations, if you could give us an overview? For example, are you holding excess cash for recession opportunities and perhaps where you’re underweight and overweight at the moment?
Owen: We are overweight duration at the portfolio level. Back to the previous point, we’re very selective about which countries we want to take duration risk in. We don’t just look at the US market and take all of our views there. So, what we’re looking for is those countries that are pretty leveraged, household debt is high, real estate markets are over-stretched and they’ll be very sensitive to the interest rates that’ve already risen a lot. So, looking around the world, you’ve got countries like Sweden, the UK, New Zealand. We talked about South Korea. These all seem far more vulnerable to higher rates than some other countries like Australia, to your point earlier. So, this is where we want to be positioned in duration.
Cash is a weird concept because we’re typically benchmark-aware investors and benchmarks, as you know, are 100% invested. So, the reason why you typically would hold cash is if you were defensive either in credit or in duration. Whereas we’re actually quite bullish on duration. We deploy most of our cash to buy longer maturity bonds at the moment, and we’re encouraging clients to do the same because we still feel that clients are trying to get the perfect time to move from cash to bonds and it’s going to be pretty difficult to decipher. And when bonds do rally, they could potentially rally quite aggressively, particularly given the bear market we’ve seen. So, we’d encourage clients to be holding a little bit less cash, if anything, and probably more longer maturity bonds.
Very good, where do you see the best opportunities for them?
Owen: So, as well as being long duration, there still are a handful of opportunities in spread product or credit, but I think there, you’re looking more at the upper quality areas. So, things like European investment grade bonds, we think are pretty attractive. Since the collapse of Credit Suisse, there has been a widening in European credit spreads relative to the US, but generally, we think the European banking sector is less risky than the market perceives. So, as long as you do your work with your analysts from the bottom up, there’s plenty of good European banks that we think are pretty attractive at the moment.
Any examples?
Owen: Yes, for instance, some of the Spanish banks like CaixaBank, UniCredito, in the UK, banks like NatWest, for instance, very well capitalized, quite conservative loan deposit ratios, high liquidity on their balance sheet to meet for any redemptions they might have on deposit level. So, these are all pretty good stories.
Terrific. In your August Fixed Income Insights paper, you said that you were lukewarm in regards to duration in Australia. You’ve probably already touched on this, but do you still hold that position given the November cash rate increase?
Owen: Yes. I think there’s easier places to have a view on the rate projections. And probably another example I’d give is in Europe. In Europe, growth is very anemic. Germany is in recession, the Eurozone is probably going to grow about 0.6% this year. So, a lot lower than some of the markets like Australia and the US. So, we really focus on where there’s very clear evidence of a slowdown and deflationary trend already. And probably the places where that’s most evidenced is in China and Europe right now.
And so, being long things like UK gilts or even German bonds to a certain extent makes quite a lot of sense to us relative to Aussie bonds. Aussie rates are actually not that high in terms of real rates as well because there is inflation here. So, if you compare real rates in Australia to other commodity exporters like Brazil or Mexico, and I know it’s hard to compare apples with apples, but we’d far sooner use their local markets because the real yield, so that’s the yield adjusted for inflation, is just so much higher and that should help their currencies, of course, as well.
What do you think about Australian interest rates?
Owen: We’ll find out next February whether that inflation trend is persuasive enough for the RBA to feel that they can stay on hold. But certainly, the labor markets look uniquely tight here.
The RBA will have to keep on talking pretty tough.
How about the UK?
Owen: We do have an election on the horizon, but both parties seem to be rapidly moving towards the center now. And so, I think you’re going to see a more prudent and conservative political situation for the next five years in the UK, which is good. There are certainly the growth headwinds, particularly the effect of lower trade with Europe is starting to be felt in economic data. The other thing, a lot of our mortgages are quite short term and they refinance now. So, for those people that do have a mortgage, it’s going to be expensive. And the cost of living crisis has also been a big issue for UK consumers as well.
So, again, a market that we like taking duration risk in. We don’t like the pound either. And so, yes, I mean the UK market is somewhere where we’re pretty pessimistic on still. So, both short the currency and long in duration reflecting that.
Okay, very good. Is there anything else you’d like to add, Owen?
Owen: I think then we have to remember, even though we’re talking about recession, there are some asset classes that are priced for recession for example, European investment grade being one of them. US mortgages are pretty attractive as are parts of the ABS market.
Really, the part that we’re defensive on is that high yield component. There’s a downing quality component. Also, there’s a lot of debate about private credit here because it has played a huge, important part in terms of successfully funding leveraged companies in the last few years. The refinancing risk associated with that is quite high because these private credit funds might not have the same investor base that they have enjoyed in the last few years when yields were very low. These companies are highly leveraged and will need to refinance the loans.
The bear market for public debt has been phenomenal. We’ve never seen such a big drawdown in bond markets, certainly in my career, really ever. But the private credit markets are, on the face of it, looking quite benign still in terms of their drawdowns. But that’s something that I would question.
You’re either very confident, or you’re not confident. In which case, you should invest in high quality credit than holding cash or government bonds. So, there’s some big asset allocation decisions for investors to make.
Owen Murfin, CFA, is an investment officer and institutional fixed income portfolio manager at MFS Investment Management. He is a member of the MFS Global Fixed Income portfolio management team. In this capacity, he participates in portfolio strategy discussions, customizes portfolios to client objectives and guidelines and communicates portfolio investment strategy and positioning. He is based in London.
