Georgios Leontaris is the chief investment officer,
EMEA, of HSBC Private Bank, managing a $1.5 billion remit. Leontaris discusses with Iain Bell, head
of Middle East content for Markets Group, the outlook for
global fixed income products.
Markets Group: Central banks are moving away from the loose monetary policy that took them through the pandemic to curb inflation. To what extent is that changing traditional fixed income markets, and how are you adjusting your investment strategy to confront that change?
Georgios Leontaris: Fixed income assets experienced among the worst returns on record this year, as the persistence of inflation and the hawkish tone of central bankers triggered a sharp rise in the expected policy rate trajectory. Signs of an economic slowdown contributed to an inversion of the yield curve and a widening in credit spreads, exacerbating portfolio returns.
Prior to this year, investors were hesitant to add to bond allocations, as pandemic emergency responses kept global yields anchored at low (and even negative) yields, turning to equities instead given the lack of other viable opportunities.
Weak performance and lingering inflation worries have held back investor positioning until now, but this could start to change in the coming months should inflation show more concrete signs of stabilization.
Although fixed income markets as a whole remain a poor hedge against inflation, the future prospects of returns are becoming much more compelling. Two-year U.S. Treasuries are at the highest level since 2007, trading at 4.5% compared to 0.23% this time last year. The market is effectively priced for a terminal Fed fund rate of 4.9% (near our updated forecasts of 4.75%) –which would mark the most aggressive expectation we’ve seen throughout the current cycle.
Although an aggressive response from central bankers is already priced in, interest rate volatility remains elevated as policymakers have backed away from commitments to forward guidance, and data dependency is becoming more important. For this reason – and the fact that the U.S. Treasury yield curve remains deeply inverted – we see no compelling reason to meaningfully extend duration. However, we take comfort from strong fundamentals of corporate bonds – which took advantage of the low-yield environment during the pandemic to extend their maturity profiles and keep higher proportions of cash on hand in precaution of the evolving economic outlook.
The risk-reward of short-term quality debt has therefore seen a compelling improvement, with entry levels unseen for numerous years. The ‘pull to par’ effect should add comfort to buy and hold investors, whereas the diversification benefits of bonds should also improve going forward. The higher yield implies a bigger cushion against potential expectations of further rate increases. Although timing the market remains a difficult exercise – we recommend long-term investors to start scaling in to the market, focusing on short-term global investment grade and select high-quality EM corporate bonds.
MG: High-yield corporates, convertibles and emerging market debt have enjoyed recent positive returns. What are the driving forces behind this and how do you balance your risk-reward ratio to ensure that you’re capturing yield but appropriately so?
GL: A relief rally was witnessed in July, as the market shifted its tune from the capitulation in the first half and positioned itself for a potential pivot from central banks to a more dovish stance. These hopes were recently put to rest after the elevated CPI report, the resilience in labor market data and the Jackson Hole symposium which signalled the intention to front load interest rate hikes to ‘get the job done’ and focus on curbing inflationary pressures.
The latest FOMC meeting went a step further, with the Fed lifting its dot-plot forecast higher for longer, even in the face of weaker growth projections. Even as spreads have widened, US high yield has managed to outperform other indices, thanks to the shorter duration and resilient earnings season from commodity linked issuers. Default rates have edged higher to 1.4% from the recent lows of 0.9%, yet remain at low levels. The prolonged inversion of the yield curve and downside risks to growth, however, warrant a bit of caution against riskier parts of the market. Our quality bias is therefore predominantly focused on short-dated U.S. investment grade but we also find value in select BB credits as well. Credit linked notes as a means of capturing positive basis on high rated issuers can also enable investors to capture an extra spread premium rather than going down the credit ladder.
Emerging market debt, on the other hand, has become so diverse that country allocation and issuer selection is becoming more important. For instance, Mexico and Brazil local currency bonds have outperformed many developed market peers, as currencies have strengthened against the USD – whereas hiking cycles started well before the Fed. On the corporate side, Middle East bonds have seen more limited spread widening, as hydrocarbon revenues have improved the credit profiles and reduced the need for new bond supply, supporting technicals. In times of market uncertainty, diversification remains paramount and investors could complement their developed market positions with high-quality corporate credit from Asia, Latin America and the Middle East.
MG: Looking at less risky fixed income –Treasury bonds, MBS, IG corporates –they’ve brought negative returns recently. Do you expect that to change in the near future? And if not, how will you adjust your portfolio?
ML: Securities with lower credit risk tend to be more sensitive to changes in interest rates, so even though spread widening is less of a headwind as we move higher up the rating ladder, investors are still exposed to yield curve changes. Even U.S. Treasuries’ performance has seen double-digit declines this year, given the erosion from inflation and the shift in the Fed’s monetary policy stance.
With inflation remaining a headwind, the Fed is now expected to hike by another 180bps by early next year, after having lifted rates by 75bps for the third consecutive time in September. The market would benefit if inflation were to show concrete signs of deceleration, or if the Fed were to signal it is looking to slow down the pace of hiking and confirm we are near the terminal rate. Positioning for a policy pivot right now, however, seems premature, as the Fed is still looking to see concrete signs of a pronounced slowdown in prices and is not ruling out future outsized moves for the time being. As we head to the final months of the year, volatility in rates may therefore prevent these assets from seeing a strong rally hence we keep duration short. On the other side most of the damage seems to be behind us with regards to the front part of the curve. Although further mark-to-market downside remains possible, the yield buffer is becoming high enough to absorb this over the medium term, and therefore we start to add short-dated bonds focusing on high-quality issuers. In the coming months, if inflation and rate outlooks reach a convincing inflection point, we could use this as a catalyst to add to riskier positions in the bond market or lengthen our duration positioning.
MG: Private credit has undergone a period of phenomenal growth since the global financial crisis of 2007-08. It seems, amid the uncertainty, investors are more cautious on the asset class. How is your approach to private credit changing, and where might you see opportunities?
GL: Private markets are gaining an increasingly important role for institutional and high-net-worth clients. The evolution of the market over the years is offering increasing choice and diversification to investors, whereas regulatory changes have encouraged issuers to turn increasingly to private credit as a source of funding. The correction in public markets (and hence greater expected returns) coupled with recession fears have made some investors more cautious with regards to the asset class. Although it is true that bonds are becoming a more reliable component of portfolios , we continue to find a number of reasons to be invested in private debt.
This year has seen one of the largest drawdowns in the typical “60/40” (stock/bond) portfolio, highlighting the effectiveness of alternative assets such as hedge funds, private equity, private debt, and direct real estate investments in minimizing downside risk in this environment. Private debt has the benefit of typically offering floating rate income streams, which have risen in line with central bank interest rates. Default rates in the high yield and leveraged loan markets remain low, near the 1% handle – and although these are likely to rise during an economic slowdown, credit analysts are not expecting them to reach disorderly levels, whereas the focus on senior secured debt and selection of instruments with more robust covenants should be a mitigant strategy.
Historically, private credit has displayed lower drawdowns and limited default rates during economic downturns, whereas the higher income and short duration of the asset class is generally well positioned for rising rates. In fact, it is worth highlighting that private investments made during crisis year vintages have historically performed very well. The recent volatility in markets could actually provide attractive opportunities for skillful managers to invest in good borrowers at better conditions. Periods of risk aversion are associated with lower ability of capital raising in public markets, implying that private funds with disciplined and rigorous reviewing processes are able to secure attractive concessions from new deals. Looking forward, our focus on private credit is geared towards senior secured loans, with strong covenants, low LTV, primarily floating and in high-growth sectors.
MG: CPI data last week indicated that in the U.S., inflation is stronger than expected. Where do you see inflation sticking and how can investors react to this in their fixed income strategies?
GL: Headline inflation in the U.S. has slowed from 9.1% YoY in June to 8.2% in September, largely due to the sequential fall of gasoline prices, which were above $5 per gallon in the summer months and have declined to $3.80 of late. The slowdown was also achieved thanks to categories such as airfares, groceries and used car prices which experienced either declines or smaller pace of gains to previous months. On the other hand, core inflation (which excludes the more volatile price categories of food and energy) has continued to move higher in the U.S., rising from 5.9% in August to 6.6% last month on a YoY basis. Rent prices now contribute towards 25% of the total inflation print, up from 20% during the summer. Shelter costs should remain among the largest drivers of core inflation in the coming months, as prices of rents remain on an accelerating path for now. The shift of consumer spending behaviour from goods to services is also likely to contribute towards the stickiness of core inflation and explaining the resolve of the Fed in hiking rates in order to restore the balance. Labor markets will need to weaken to a certain extent, in order for wage prices and demand driven inflation to come down, and the Fed’s latest forecasts suggest an increase in the unemployment rate to 4.4% should be consistent with its latest economic assumptions.
The false hopes of a policy pivot in July/August offered an opportunity to overweight floating rate notes over fixed instruments and a renewed opportunity to look at TIPS. The latter are too expensive in our view, but they could offer diversification to investors who remain pessimistic about the prospects of inflation. Although not the most effective hedge against inflation, long-only investors should consider energy-sensitive sectors or exporting nations where the strength of credit profiles may offset part of the pressure from higher rates. Fixed maturity products with limited duration can be considered for buy and hold investors, whereas cash enhancement and cash alternative solutions such as cap and floor products can be increasingly incorporated in portfolios at current levels.
MG: It’s clear that Europe is going to face a very difficult winter, given the situation with energy prices. What will be the impact of recession in Europe on fixed income markets and how do you plan on navigating that?
GL: European gas prices declined below €100 MwH for the first time since June, largely due to faster than expected increase in gas storage, which has exceeded 93% of total capacity even as Nordstream 1 pipeline remains closed indefinitely. The market has also taken comfort from expectations of milder temperatures this winter, as well as recent fiscal packages and an EU roadmap aimed at curbing price pressures and redirecting energy revenues to alleviate the cost-of-living squeeze. Despite these developments, the outlook for Europe remains challenging, given that demand is still set to increase during the colder winter months whereas further supply disruptions would require a reduction in demand that would weigh on economic activity should it entail rationing. In their “adverse scenario,” the ECB warned the Eurozone would contract by negative 0.9% next year, although other economists have issued starker projections.
A mild recession would not come as a big surprise to investors, who are already braced for stagnating growth and elevated inflation. A deeper or longer than expected scenario however would have a number of implications for bond investors. Firstly, a recession would complicate the ECB policy trajectory, as it would likely consider fewer rate hikes than the 230bps currently priced in by June 2023. Safe haven demand and a potential central bank pivot could ease some of the pressure on core government bonds, with bonds currently trading at levels seen during the Eurozone debt crisis. Peripheral spreads would likely remain under pressure, but participants would keep an eye on the ECB’s response, and whether the anti-fragmentation tool would be triggered to contain the pressures.
In credit, higher-yield spreads could widen further – but the depth and severity of a recession would influence the potential move. Cyclical sectors and industrials would see a larger impact on profitability. Financials would also be affected by rising delinquency rates – but it is worth highlighting the capital buffers of banks should be able to absorb most of these shocks. A mild recession is not anticipated to trigger a banking crisis, but investors could nevertheless look to move up the capital structure by focusing on senior or Tier 2 instruments in our view. Foreign issuers of EUR denominated paper can complement geographically diversified portfolios, whereas strategies able to invest in other currencies could add unhedged USD credit, whose issuers should be more immune to a European recession. A selective approach in high-quality, short-term bonds remains our preferred positioning within the European space, as we balance our baseline economic scenario with potential downside risks.
MG: Finally, moving to emerging markets—where is the growth in fixed income markets and where are you looking to increase exposure to, if at all, and what are the underlying reasons for that?
GL: A strong USD, slower economic growth, rising U.S. rates and geopolitical risks are typically factors hindering emerging market assets. It is worth however noting that USD Corporate bonds have not underperformed Developed Market peers, whereas select local bond markets such as Mexico and Brazil have actually delivered positive returns this year.
From an asset allocation perspective, we favor short-dated hard currency EM Corporates over local currency debt going forward given that we are mindful of taking currency risk against our strong USD view. Within the corporate space, Middle East issuers have been a clear winner this year, with the IMF forecasting the region will see $1.3 trillion additional hydrocarbon revenues until 2024 thanks to elevated oil and gas prices. Resilient growth, lower price pressures, a shift from deficits to surpluses, lower bond supply, government support are few of the factors that should contribute to resilience of the Middle East market. Strong ratings, low duration and government support also favor Asian markets. Despite being energy importers, the risk of energy disruptions is much lower than Europe. We underweight volatile sectors such as Chinese real estate but favour quality champions in the region. Bond pickers can also look at commodity exporters in Brazil and investment-grade issuers in Mexico when building portfolios.
Interview by Iain Bell