Investors should prepare some dry powder in their portfolios to take advantage of a better buying situation should the credit markets falter in the US, a senior fixed income manager has warned.
Anton Eser, co-head of global fixed income at Legal & General Investment Management, said that the impact of tighter US monetary policy was being underestimated by markets.
He said: “Two years ago, markets were unsettled by the potential of the Federal Reserve imminently tapering its QE programme. During this taper tantrum, bond yields rose, equity markets corrected and high-beta credit markets such as high yield and emerging markets saw heavy fund outflows and sharp price falls.
“Today the stakes are much higher as the market steps into the unknown, turning its attention to the Fed’s first rate hike since 2006.”
He pointed to long-term structural problems associated with LGIM’s 4Ds – debt, deficits, demographics and deflation, which he said have not been resolved by years of easy liquidity. These vulnerabilities could reveal themselves as interest rates go up, and there could even be a fourth round of QE for investors to consider.
Mr Eser added: “There is a worry that only a handful of rate hikes will be enough to slow the economy to such an extent that the Fed pauses and even considers reversing policy.
“Even if yields do not move substantially higher, the 2013 taper tantrum demonstrated that such volatility can lead to fund outflows and wider credit spreads, leading to a period of negative total returns.
“Therefore investment grade credit markets have a backdrop of higher interest rate volatility with significant tail risks across emerging markets and Europe. We want to be in a position to take advantage of such a scenario with plenty of dry powder in the portfolios”.
His comments came as Gustavo Medeiros, portfolio manager for Ashmore, called the Federal Open Market Committee’s minutes in June a “clear message for investors”. At some point, when the economy wakes up from its current lethargy, the FOMC will start the process of interest rate normalisation as soon as the economy exhibits some signs of improvement from its first quarter lethargy.
However, like Mr Eser, who is keeping his powder dry, Mr Medeiros said investors should not fear the looming hiking cycle, as any weakness in asset prices should be an opportunity to add to positions.
He said: “This argument is based on empirical evidence that hiking rates is not the main event which derails Emerging Markets assets. EM credit spreads actually tighten during the period when the Fed is hiking interest rates. This has happened twice, first during the 1998-2000 hiking cycle and secondly during the 2004-2007 cycle.
“The lift-off is bound to coincide with a period when US growth is on a recovery path; lifting global growth prospects as the US economy starts hitting supply constraints and begins to import more of the goods and services it consumes.”
Instead, he said investors should fear a sudden spike in global risk aversion, leading to a strong liquidity contraction, which would push credit spreads wider across the board.
According to credit history, this widening of spreads typically happens either just ahead of the Fed hikes, as it did with the Russian Crisis and the failure of Long-Term Capital Management in 1998, or long after the hiking cycle is over, when the tightening of monetary policy feeds through the economy and the higher cost of funding eventually tips one or more sectors into liquidity problem, such as the banking crisis in the US in 2008.
Mr Medeiros said: “Thus, considering the current point in the cycle, we would consider any sell-off led by the ‘fear of the Fed’ as an opportunity to add.”
