This episode focuses on why fixed income investors should consider the global implications of surging inflation, decelerating growth, and realignment of the global and geopolitical landscape. George Bory, chief investment strategist for Allspring’s Fixed Income group is joined by Henrietta Pacquement, head of Allspring’s Global Fixed Income team, to discuss her economic outlook for Europe and strategies to extract value in fixed income portfolios.
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George Bory: I’m George Bory, chief investment strategist for Allspring’s Fixed Income group, and you’re listening to On the Trading Desk®.
Today we’re discussing why all fixed income investors should consider the global implications of surging inflation, decelerating growth, and realignment of the global and geopolitical landscape.
Joining us is Henrietta Pacquement, head of Allspring’s Global Fixed Income team, to discuss her economic outlook for Europe, how it aligns with factors in the U.S. and Asia, and strategies to extract value in fixed income portfolios. Thanks for being here, Henrietta.
Henrietta Pacquement: Hello, George. Thank you for having me.
George: It’s great to have you on the show. So, let’s kick off with a couple high level questions and let’s really kind of think about the macro backdrop. I think given all the challenges we’re facing in today’s markets, it’s best to just start with the basic principles. What are your team’s expectations for growth, for inflation, and for unemployment?
Henrietta: All good questions, George. And here’s some context. So like the U.S., Europe has really had a scissor effect in 2022. We’ve had growth expectations go down and inflation expectations go up. Just to give you an order of magnitude, in Germany, for example, growth estimates have now declined to some 1.5% for this year. At the same time, inflation estimates have ballooned to 7.5% and counting.
Now, some of the inflation drivers that we’re seeing in the EU (European Union) are similar to the U.S. I’m thinking the supply chain bottlenecks, for instance. But the primary factor driving inflation on this side of the pond has been the fallout of the Ukrainian conflict. We’re seeing pricing pressures in energy and food. And those have been a lot more prevalent here.
In terms of employment, yeah, it’s tight in Europe, but it’s not as tight as what you guys are seeing in the U.S. As a result, we’re actually dealing with core inflation in Europe at a much more palatable 3.7%, some 2% lower than what is being seen in the U.S.
Now, nonetheless, this is a dynamic that has seriously complicated the work of the ECB (European Central Bank). And we’ve actually seen how they’ve responded just yesterday. And from my perspective, it’s actually quite an aggressive response from the ECB by their standards. And we’ve finally left the realm of negative base rates in the Eurozone. And we did that in one go.
Now, of course, Europe wouldn’t be Europe if that wasn’t accompanied with a new acronym to deal with a challenging situation that we’re facing at the moment. So, the hike was actually accompanied by what is now called the TPI. So that is the Transmission Protection Instrument. So, this is the latest tool in the ECB’s ever-expanding toolkit to keep European spreads under control. And this confirms the close second mandate of the ECB apart from price stability, and that is really preserving the Eurozone project.
So, you might ask why so aggressive now? Well, from my perspective, there are a number of reasons, catching up with the Fed (Federal Reserve) is one to support the euro currency. But the key driver that we think is that it’s similar to what you’re seeing in the U.S. The ECB is front-loading its hikes in the lightly limited time it has left before what promises to be a challenging winter from an energy perspective.
So, I mentioned a German statistic to start off with and that wasn’t gratuitous. Germany is going to be the most impacted by gas shortages, should they accelerate later on this year. And we’ve actually already seen that today in the PMIs (purchasing managers index) that have come out. And the reason is that Russian gas is a key component of Germans’ efforts to move toward cleaner energy sources because they’ve been running down their thermal coal. They’ve been mothballing their nuclear power production in recent years. And we expect this situation really to be actually negative from a transition perspective short term. However, in the longer term, we see that as a positive development, as Europe weans itself off fossil fuel dependency.
George: From your perspective, how do you define value? Bond investors look at value in a very unique way. We like to say value is in the eye of the bond holder. But when we look at aggregate yields, aggregate yields are still quite low. They might be off zero at the very front end of the of the curve. But overall bond yields are still very low and inflation is still very high. So how do you sort of square that circle and identify value in your fixed income portfolios, as you think about strategies for the second half of the year?
Henrietta: Obviously, the stars of this year and, H1 (first half) in particular, have been extremely challenging for investors. And we’ve had a few places to hide. I would argue, though, that the flip side of that is that your yields and spreads now are a lot more attractive globally, not just on the European side, than they were at the start of the year.
Now, investment grade spreads in Europe are now hovering around 200 basis points. And that compares to 150 in dollars. And for me, that actually rightly prices a higher likelihood of a slowdown on the European side compared to the U.S. But it also provides value.
The last time investment grade spreads were at these kinds of levels, apart from the COVID interlude, is back in 2012. So, we’re going back to the sovereign crisis to get to these levels. And at 150 basis points of dollar market, we’re actually only looking back to the slowdown that we saw in 2018 for that kind of spread. So much less uncertainty is priced in there.
To give you an idea, blue chip reverse-yankees are now trading some 10 basis points cheaper in euros than their dollar counterparts. And the U.S. portion of the euro index is at some 170 basis points.
Other interesting area, after years of cleaning up their balance sheets, building up their capital buffers, the debt issued by European banks actually provides interesting levels with spreads around 180 basis points for banking spreads.
Now, what’s interesting here is, yes, of course, we are heading, as I mentioned earlier, into what is likely to be a potentially challenging end to the year, driven by what or may happen on the energy side. But if you look back at first quarter earnings, results have actually come on strong despite the inflation and the growth headwinds.
Companies have been more conservative in terms of their use of balance sheets. They are positioned pretty solidly from a financial perspective and are in a decent shape to handle the more uncertain economic environment that they’re likely to face in the second half. Now we have seen the beginning of profit margins declining and that is to be expected given the pricing pressures that we have seen. But we’ve also seen a pullback in debt growth and leverage remains pretty flat at the moment. Now for sure, interest expense has risen and will continue to rise as we’ve seen interest rates rise. So, it’s good that the companies at this stage have got a solid balance sheet.
I think what’s also interesting to note here is even in sub-investment grade, if you look at high yield and leverage loans, they’ve really caught up in terms of spreads to the movement that we’ve seen a bit more steadily on the investment grade side. And we’ve got a better ratio between investment grade and high yield at this point. I mean, we’re at 600 basis points on European high yield after what was a pretty brutal month of June. And we’ve seen a similar phenomenon in loans, for instance, that had actually held up remarkably well at the beginning of the year because of that floating rate nature.
So those are elements to note and the valuations are a lot higher than we have seen definitely in recent years. And not only that, what is interesting for high yield and leveraged loans is that corporates have been terming out their debt over the last few years and we’re only likely to sort of hit more of a maturity wall towards the 2024-2025 period.
George: While the background might be challenging, it seems like many of the challenges are priced in the market. As you point out, there is good value in bond, particularly when we look at spreads and we look at spread differentials between, say, the U.S. and Europe. And I think that sounds like that’s the good news.
But you’re in the business of pulling this all together and building portfolios for our clients. So how can investors monetize some of these opportunities? And what kind of style have you been pulling in your portfolios to build a stable form of cash flow that clients can be highly confident are going to function through time as we go into the end of this year and into next year?
Henrietta: Looking ahead and looking at the portfolio construction and the exercises that we’ve been going through over the last few weeks, the solid corporate fundamentals at this point and the higher level in yields, we think, again, to be supportive for the global investment grade market going forward.
Now, our preference is still up in quality. And we like exposure to a combination of rates and spread because we’re starting to see a bit of a return of a negative correlation between credit performance and rates performance, as we have this battle between the fear of inflation and the fear of recession.
So, we are looking for companies with robust balance sheets that don’t necessarily need to come to the funding markets, or at least have proven access to liquidity, and also have pricing power, given the environment that we’re in.
That being said, given the recent moves that we’ve seen in certain cyclicals, and as I touched on the sub-investment grade and even some of the subordinated issuance, we are seeing opportunities popping up for what I would say, the seasoned stock picker, and also for investors that have got a slightly longer time horizon, maybe 6 to 12 months to see these investments perform.
And it’s always a lot easier to pick up interesting yields in credit when technicals are poor and investors are running for the hills. And if you look at the markets at the moment, they are quite technical. If you look at investment grade, just last week, we actually saw the IG ETF (investment grade exchange-traded fund) trade at a premium as Russia turn the gas taps back on, post the servicing that they had to do for 10 or so days. And that was enough to cause a bit of a technical squeeze that brought spreads over the course of this week, as we’re in a situation where banks currently are actually running with little to no inventory on the credit side. So, I think that’s something to look at.
Another source of opportunity going forward and that’s likely to pick up more post-summer is the new issue pipeline. And our sense there is that corporates are going to have to come with a new issue premium. Again, that is a nice area for credit investors to pick up spread, yield, and opportunities in the market.
Now we fully appreciate that markets have got a lot to get through over the next few months, so we do expect volatility. But at these levels, it’s worth doing one’s homework from a research perspective to figure out the names where one has confidence to carry them through potential bouts of volatility.
The starting yield cushion is looking a lot more attractive, both from a rates and a credit perspective. And we think diversification is going to be key. So, we talked about global and that makes sense, looking at the global spectrum of credit to get the best risk-adjusted opportunities.
Another theme, actually, that we’re seeing from our clients is focus on climate considerations. And from the comments that we’ve had in terms of the energy considerations at the moment, it is a key consideration. And climate transition remains a big topic and something to consider when selecting securities for a portfolio. And we’re really seeing investors trying to balance financial considerations and support decarbonization going forward. So that’s the thematic that we’re seeing across asset classes and in fixed income in particular now.
George: So just to wrap it up, what would be, say, the three most important considerations that you would want our listeners to take away from today’s discussion?
Henrietta: Looking globally would be one and really considering opportunities across the global credit spectrum. I think you mentioned valuations. Global markets are more bond-friendly now compared to the start of the year and we have a situation where value is better aligned with economic realities. And as you mentioned, security selection is going to be key. We do expect to pick up in terms of defaults over the course of the next few months and years. So, that needs to be a focus when selecting securities for a given portfolio.
George: Henrietta, thank you very much for being with us today and sharing your insights.
Henrietta: It was a real pleasure, George. Thank you.
George: That wraps up this episode of On the Trading Desk®. If you’d like to read more market insights and investment perspectives from Allspring Global Investments, you can find them at our firm’s website, allspringglobal.com. And to stay connected to On the Trading Desk® and listen to past and future episodes of the program, you can subscribe to the podcast on Apple Podcasts, Spotify, or wherever you get your podcasts. Until next time, I’m George Bory and thanks for listening.
100 basis points equals 1.00%.
Diversification does not ensure or guarantee better performance and cannot eliminate the risk of investment losses.