While we might hope for an economic soft landing, Jack Holmes, co-manager of the Artemis High Income Bond Fund, is not sure we’ll get one. He looks at what this might mean for income investing.
The market has at times this year become very excited by the prospect of a so-called “soft landing”. This is where you know the plane is in trouble and facing stormy weather but there is still a chance the pilot will drop it smoothly onto the runway to loud cheers from the anxious passengers.
In economic terms it means activity becoming a little less frenetic but still growing gently, while inflation painlessly eases down to levels that allow central banks to cut rates, to the relief of one and all.
We struggle with this narrative for two reasons. The first is that the bedrock of long-term inflation – wage levels – appear to still be increasing across most developed markets at levels that are inconsistent with rate cuts.
So, while headline inflation has fallen significantly this year, the “core” elements that naturally take longer to come down (and are less related to energy prices) have been notably slower to start the journey down.
The Labour market in the US still looks remarkably strong. Last month the United Auto Workers’ Union negotiated a 25% pay rise over four years for its 57,000 members at Ford, including an immediate 11% hike. The Bureau of Labor Statistics estimates that year-on-year wage growth for union members there reached 4.6% and you sense the number is still rising.
All of these combined make inflation look more sticky, and therefore also make the idea of an easy path to lower inflation and subsequent “painless” central bank loosening unlikely in our eyes.
Secondly, monetary lags are unpredictable in both their timing and impact. Based on past experience, central bankers have little or no ability to “fine-tune” their policy. The chances are high that they will eventually reach a point where they tighten too much and economies start feeling much more significant pain.
In the same way that economic growth and inflation are self-reinforcing, economic downturns build on momentum. Therefore, the perpetual goal of central banks – to tighten just enough to slow down the economy, without causing meaningful damage – is incredibly hard to achieve. Given the unprecedented environment today (in terms of inflation, deglobalisation, inflated central bank and government balance sheets, alongside one of the steepest hiking cycles in modern central banking history) we believe it unlikely that central banks will succeed in finding the perfect balance on monetary tightening to allow for an eventual soft landing.
So what happens next? All we know is that the scenario rates markets are currently pricing in is almost certain to be incorrect. In our minds, we will either see a meaningful rolling over of data – in which case the Fed could reach for the defibrillator and cut rates by 200bps or more to administer a shock to the system and revive it (as a reminder, around 90bps of cuts are priced for next year). Or we will see a continuation of this year, with entrenched inflation, a resilient economy, and a need to keep monetary policy relatively tight. Unfortunately, we have no great insight into which of these will be the case.
That does not mean we are powerless. We can set up portfolios in such a way that they perform well in both scenarios. That means focusing on better quality credits, which can survive in a higher-for-longer scenario (largely by producing large amounts of cash flow with which to meet higher debt costs or starting with low levels of leverage to begin with). Within this part of the credit market, we are tending to focus on the front-end of the curve as we believe we are getting very well paid here to take reasonably conservative, lower-volatility exposure.
On the other side of the coin, we believe some of the longer-duration parts of the government bond market provide the opportunity for reasonably priced long-term exposure that is likely to provide a very useful hedge whenever economic performance and risk assets crack. The 20-year part of the US curve (particularly in inflation-protected TIPS) look compelling on the grounds of attractive historical valuations and given that TIPS are the natural go-to safe-haven asset. We also like the two-year to 15-year part of the gilt curve which is not pricing in rate cuts as aggressively as in US/Europe and where we are seeing more tentative signs of macroeconomic weakness which could put into question the higher-for-longer rates narrative.
Individual investors and advisers may be asked where is the most attractive place to be right now – investment grade or high yield?
Ultimately that depends on how an investor’s portfolio is set up. If an investor is looking for some balance to a portfolio that otherwise has a lot of cyclical growth exposure, government bonds or investment grade likely fit the bill well. If an investor has a lot of exposure to longer-duration assets (such as “quality growth” stocks, or US tech), high yield might be a good place to get some cyclical, high-income assets to balance this positioning. Currently we regard the front-end of both high yield and investment grade markets to be attractive, allowing for investors to generate high levels of income without having to take a large bet on whether the rates cycle is about to turn.
In short, we all hope for a soft landing but we are braced for trouble, and believe it is possible to position portfolios to weather a number of different storms. The good news is that fixed income offers more value across the board than at any time in the past decade, whether you look at government bonds, investment grade, or high yield. Yields are now at levels where investors should be actively considering their options in, and allocating to, fixed income. A flexible fund such as ours allows investors to get the core exposure while allowing for the potential for additional value to be added through our finding the “sweet spots” of the market today.
