This week’s Investment Q&A from Fund Calibre is with Elite Rated manager Mike Riddell, manager of the Allianz Strategic Bond fund. Mike outlines why he believes understanding the global economic environment and why identifying mismatches between market pricing and actual risk, is so important for bond investors. He explains that while markets are currently pricing in minimal risk of recession, his fund remains flexible, employing tactics such as investing in government and corporate bonds, taking inflation views, and even investing in currencies.
(Recorded 15 August 2023)
[00:30] As a genuine strategic bond fund, you take a flexible approach, and you are very much focused on the macro environment. Since early 2022, your view has been that we’re underestimating the risk and depth of a recession. Do you still have that view that we’re still heading to a recession?
[02:28] So, just to give a couple of examples, if you look at corporate bonds, normally the extra yield you get on corporate bonds over government bonds kind of tracks the economic cycle. So, if markets or investors believe there’s a risk of recession, then so-called credit spreads are very wide – in other words, you’re getting much more yield on a corporate bond than a risk-free government bond. But when there’s no perceived risk of recession, then you find that that extra yield in corporates is very little – in other words, credit spreads are very tight. And where we are today, we’re actually seeing risky assets like corporate bonds, saying no real risk of recession.
The extra yield you’re getting on corporate bonds over government bonds is in line with the average of the last 10 years, so, that’s the market really implying that we’re going to have moderately strong growth over the next 1-2-3 years. And that’s just on corporate bonds.
[03:16] But actually if you look at government bonds, you get a similar picture. I mean, government bond yields are very high. Government bonds have had the biggest selloff really in history over the last couple of years. It’s been incredibly violent. Yields have gone from historic lows to really the highest in a few decades in some cases. French government bond yields are now today the highest they’ve been in over 12 years, so we’re seeing very elevated government bond yields. People might assume that’s because inflation is very high, but actually inflation’s been coming down really quite quickly and the UK’s a bit of an exception here, but if you look at the US, inflation is just above 3% and it was almost 10% in the summer of last year. Similarly, in the Eurozone inflation got to above 10%, today it’s just above 5% and it’s continuing to move lower. So, we’re seeing really inflationary pressure go away.
[04:06] Inflation markets are saying that there’s not really any inflation problem. I mean, markets are always forward looking and they’re basically pricing in inflation moving back to target in the next one or two years. The reason that markets are expecting interest rates to remain extremely high we believe is because markets think growth is going to remain very strong. And this we just do not agree with. Our view has been we expect a recession, we just don’t know exactly when it’ll happen and that’s been our view really for 12 months.
[04:55] What people and markets don’t seem to appreciate is that it takes at least 12 months for an interest rate hike or indeed an interest rate cut to have any impact on the economy. So, we’re probably going to see the Bank of England hike interest rates again in September. But the economy won’t feel that until September of next year. All of these hikes that we’ve had over the last 12 months haven’t really caused a slowdown yet, but they’re about to. This is why we do expect a recession and when we look at what markets are pricing in – really any market you like – it’s just simply not pricing in that risk of recession.
[06:00] So are you heavily invested in government bonds with little or no corporate exposure – or are you even short corporate bonds at the moment?
Yes, we are. Within our fund, we have the flexibility to not just be underweight of corporate bonds versus a benchmark, but we have the ability to actually go a bit short as well. Today, about 20% of our fund – and we wouldn’t go really any higher than that – but 20% of our fund is outright short of corporate bonds. Given that credit spreads are fairly tight then, if we are wrong, we can’t really lose much because they’re already quite tight. There’s very little downside from what we’re doing, but if things really blow up, we could make a lot of upside.
[06:50] That’s a kind of asymmetry we really like, where if we’re wrong, we don’t lose much, but I think that where we are today in markets, if we’re right about recession, then we could make a lot of money.
[07:53] As we’ve learned in the last two years, there’s definitely risk involved with buying a government bond and interest rate risk is something which sometimes can be really bad – and indeed the last two years it’s been really bad – but we like interest rate risk right now. In the bond world, we really like interest rate risk because if interest rates do start coming down and come down more aggressively than markets are pricing in, then that’s where you can get really big capital gains. So, yields going down means prices going up and potentially by a lot. And we are really positioned about as bullish as we can be on government bonds where we really like interest rate risk because we think that markets are simply wrong.
And to put some numbers around this: in the US, the Federal Reserve has interest rates above 5%, but the market is saying, never again in the next 10 years at least, is the US going to have interest rates below 3.5% ever. In the UK similarly, the market’s saying that the Bank of England’s going to keep interest rates now above 4% for a number of years, and this is what we disagree with, is that at some point in the next year or two when there’s not really an inflation problem anymore – which is our view and indeed seems to be what inflation markets are pricing in – but at some point something will happen. There could be some kind of crisis, but in particular, if there’s a recession, why does the Bank of England have to keep interest rates at 4% or 5% if growth is negative and inflation’s at target? It doesn’t make any sense to me, but that is exactly what’s priced in. So, if we do start to see interest rate cuts coming through next year and something does happen, then that’s where you can get really big capital gains in owning government bonds.
Listen to the rest of Episode 272 of the Investing on the go podcast series, including Mike discussing the following:
- [10:01] What’s causing frustration for the manager today
- [11:14] The manager’s view on last year’s underperformance
- [13:09] How long until the recession arrives?
- [13:31] The different scenarios that could cause a recessionary crisis
- [15:24] The known, unknown of China — and what that means for investors
- [16:01] Why news from China could potentially destabilise the global economy
- [17:29] Why, ultimately, interest rates remain the main risk for a recession
