By Andres Sanchez Balcazar, Pictet Asset Management
Absolute return fixed income strategies can help investors ride out market volatility even when the unexpected happens.
Bond yields are rising sharply, central banks are getting ready to trim stimulus and clouds of political uncertainty hang over much of the developed world. In our view, in tough conditions like these, when bond investors can no longer count on falling interest rates to generate performance, flexible absolute return strategies will prove to be a more reliable source of income and capital protection.
The key is not just to identify pockets of value in the market, but also to combine that with stringent scenario analysis that aims to create a more favourable trade-off between risk and return. The result is a portfolio that we believe will perform well over the long term.
Riding through EM turbulence
How does that work in practice? Our investment positioning in emerging market provides a good example.
Emerging market hard currency debt is one of our key mediumterm investment convictions; we like the asset class because it trades at cheap valuations and because emerging sovereign borrowers possess a relatively strong capacity and willingness to repay debt. During the first nine months of last year, this was indeed one of the best performing asset classes within fixed income, delivering returns of 8.5 per cent – unusually good in today’s low-yield world. In November 2016, however, the tables were turned. Donald Trump’s victory in the US presidential election and a stronger US dollar sparked a sharp sell-off.
But we were prepared. That’s because when we decided to invest in EM debt, our scenario analysis showed the position could be a volatile one. So to shield the portfolio from any potential swings in that market, we combined the investment with short positions in EM currencies versus the US dollar. In doing so, we believed we could achieve a more favourable trade-off between risk and return. The position has begun to bear fruit.
As investors sold out of bonds from Latin America to Asia, the currencies of those countries dropped. In fact, the retreat on the foreign exchange market was more pronounced than in the fixed income space. By being long US dollar EM bonds and short EM currencies, we were able to generate good returns from the combined position over the year, securing an advantage over investors just holding a long position in EM debt.
Preparing for Trump: a tale of two scenarios
We are sticking with this EM investment pair into 2017. The short currency position should generate good returns if the US president elect delivers on his pledge to crack down on global trade, while the bond investments should win out if he softens his stance on protectionism.
There are other ways in which we have accounted for potential Trump U-turns in our portfolio. In one scenario, we can see him go, metaphorically speaking, “guns a-blazing”, and try to achieve as much as possible during his first 100 days as president. That would involve implementing his fiscally-expansive campaign pledges such a cut in the corporate tax rate to 15 per cent from 35 per cent and USD500 billion of infrastructure spending. To counter this fiscal stimulus and the inflationary pressures it would unleash, the US Federal Reserve would probably respond by speeding up interest rate hikes. In financial markets, the dollar would likely do well against emerging currencies, benefitting from both Fed monetary tightening and from a Trump-induced pick-up in economic growth.
Under a different scenario, we assume it would take longer for Trump to push through his policies and that some of them may be moderated or even abandoned along the way. The current status quo – of relatively modest fiscal stimulus, a friendly stance on global trade and gradual tightening from the Fed –will thus prevail for a while longer. In this instance, we would see value in longer-dated US Treasuries and investment grade corporates, both of which are priced for much higher levels of inflation than would be likely to materialise.
Instead of trying to predict Trump’s moves – a thankless task as recent events have proven – we think a far more prudent approach is to prepare for all eventualities. That means going long the US dollar versus emerging market currencies, whilst supplementing the position with a small overweight in 30-year Treasuries and an allocation to bonds issued by US industrial
