This week’s investment soundbite Q&A from FundCalibre is with Stuart Edwards, manager of the new Elite Radar Invesco Tactical Bond fund, who talks to us about the magical world of fixed income. He discusses the opportunities in different parts of the market and gives us his view on the path for the UK economy and inflation.
(Recorded 23 May 2023)
Tell us a little bit about the Invesco Tactical Bond fund.
The Tactical Bond fund is the most flexible strategy in the Invesco stable of products. It was conceived with a view to draw upon the resources within the team, all the best ideas be that investment grade credit, high yield, interest rate strategies or emerging markets as well. To my mind, it’s a great product for the current volatile macro environment that we are in.
Interest rates have moved dramatically, and as we know there’s a direct relationship between interest rates and returns on bonds. How have you been playing that over the last year or so?
The first point I’d make is that valuations have changed significantly. If you think about the three-year period up to the end of 2021, 10-year UK government bond yields were less than 1% for most of that period. And if you look at the equivalent German government bonds, it was negative, which now seems quite extraordinary. So, there’s been a massive, massive change in valuations, and in that earlier period, we just didn’t like them. We just felt that bond yields were too low, and you really weren’t getting paid for taking risks. And, of course, that’s now changed. So we have adapted our strategy accordingly over the past 18 months, even though we would happily concede that the macroeconomic risks as they relate to growth and inflation have increased, and valuations have changed.
We’ve increased our duration exposure recognising that with all of the monetary tightening that’s in the system, eventually – and it is complicated to pitch it, because there’s lots of conflicting data – but eventually, that will lead to slower economic growth. So, in that type of environment, it does make sense to us to increase the duration exposure of the fund.
How can you make money from duration?
Most assets that have an income stream do have an element of duration. What has been interesting in the last couple of years is that there were periods when tech stocks, for example, took a really big hit. And that was less to do with views over the structural outlook and the ability to generate profits and it was more about changes in interest rates. And in so far as that affects what are essentially long growth assets.
Fixed income assets by definition – because they have a fixed income stream over a period of time – are more sensitive to changes in interest rates. So, if interest rates go up, that means the future income stream is discounted at a higher rate and the price of that income stream – or the price of the bond – falls. And of course, the longer the maturity of the bonds, that means that there’s more income streams in the future, the greater the sensitivity to changes in interest rates. So, it works in both directions. When interest rates fall, then bond prices rise. That’s basic sort of bond maths as it relates to duration.
And of course, it’s also not just about the interest rate today, but it’s also expectations for the future. And if you expect economic growth to progressively become more challenged as we do, then you can have more confidence – given current valuations – in increasing the duration profile of the fund. Now, if you go back 18 months in this fund, because of the nature of the fund and the fact that it is very flexible, we had a very, very, very defensive position on duration. In fact, it was around zero, it was that low, and a typical investment grade fund would’ve been closer to seven. So, we just really did not like valuations at the start of 2022.
You’ve got a bit more emerging markets exposure in the fund, so have you increased risk on the fund?
If we take the bigger picture – and really to simplify – 2022, to my mind was about inflation. It was the inflation shock, and it was the way central banks responded to that. They were behind in the interest rate cycle, and they had to hike rates aggressively, which as we know has led to this huge drawdown in fixed income markets and bond markets. And then 2024, if we think forward, I can foresee a situation where economic growth really does start to deteriorate as the lagged impact of monetary tightening really does start to bite.
But this year is quite messy. I describe it as a transition year between inflation risks and growth risks. So, in a sense, it’s not necessarily obvious that you want to be really loading up on risk or be really defensive at the same time; we have to acknowledge that valuations are a lot better. So, it’s about finding pockets of value whilst also thinking about the big picture.
What does that mean? Well, in one sense, we’ve increased our interest rate exposure in the fund – so we’ve taken the duration risk up. We’ve taken it up, recognising that government bond yields are more attractive, and recognising that we’re probably in a progressively deteriorating economic environment, which will take time to appear. At the same time, we’ve reduced our high yield exposure, thinking that this deteriorating economic environment raises the medium to longer-term risks of holding that asset class.
Emerging markets is a really broad church, and we have to remember that. You have hard currency emerging market bonds, and we also have local currency bonds as well, which are bonds issued by the larger emerging markets in their own local currencies where the sensitivity to their own interest rate cycles is a lot greater. The reason why we’ve increased our exposure in some very selective opportunities is because some of these central banks have, if anything, been even more aggressive than the Bank of England and than the US Federal Reserve in raising their interest rates quite aggressively. So, think Mexico, think Brazil. And as a consequence, we’ve found some quite attractive valuations in these markets and they’re paying some very attractive yields.
What is your outlook for the UK today?
If you go back a few months back to the autumn of last year, it was a particularly tricky period. We had the onset of the cost-of-living crisis, which was clearly being exacerbated by higher energy crisis which impacted the UK’s terms of trade. The pound fell and it was a very, very precarious environment. And then of course, we had the mini budget, which led to an increase in expectations around Bank of England policy rates. So, all of these things sort of conspired to create a very, very negative narrative for the UK economy.
So, actually what we find now, relative to those expectations, is that the UK economy hasn’t been as bad as most analysts had really been expecting. Energy prices have come off and actually the Bank of England hasn’t had to hike as much as what was projected at the time. But what I would say is that, going forward, we’ve still got a lot of the monetary tightening still to feed through. Only recently the Bank of England themselves did an analysis of the transition mechanism monetary policy as it relates to the mortgage market, for example, and they made the point that interest rates have gone up – for new mortgages – have gone up 300 basis points, that’s 3%. But actually, on average, for most people who have a mortgage, rates have only gone up by three quarters of a percent because there’s far more fixed mortgage rate deals now than there were when I was making these forecasts 20 years ago in my previous job at Standard & Poor’s.
I think that the economic environment is going to remain challenging, and as more and more mortgage deals come up from renewal, then that’s going to hit people’s pockets. I’m reasonably downbeat on the economic environment heading towards the end of this year and into 2024.
What’s your view on inflation?
I’m quite skeptical about inflation or this idea of an immaculate disinflation. I think it’s going to be a bit of a tall order for inflation to head back towards central bank targets cleanly, anytime soon. And that’s not just in the UK, that’s elsewhere too. On the other hand, what I would say is we are probably past peak headline inflation. And that stands to reason given that energy prices have come off and, barring a significant reacceleration in energy prices or commodity prices, then I think we’ve probably seen peak headline inflation that was likely last autumn.
But core inflation is a real mixed picture. On the one hand, goods prices have come off because many of the supply bottlenecks that we witnessed last year and in 2021 have eased; so, think transportation costs, shipping costs, et cetera. But then on the other hand, services inflation is proving somewhat stickier than people had hoped for. Why is that? I wouldcite two reasons. Firstly, as we’ve come out of Covid and economies have opened up, there’s a lot of demand for travel and leisure and restaurants, et cetera. And then there’s also private sector wage stickiness as well. It’s not surprising that private sector workers and indeed public sector workers – as we’ve seen with a lot of the strike action in the UK – are pushing for higher wage settlements, because of the high levels of inflation. Eventually, inflation pressures will ease because if the economic environment is slowing, then it makes sense that profit margins, which up until this point have really held up and been supported, will likely be eroded away as the economic environment becomes a lot more challenging. So, I think eventually inflation pressures will ease, but it’s a tricky path to that destination to my mind.
Listen to the full interview here
