Fiscal deficits are fixed income’s biggest risk

In this Q&A DNCA portfolio manager and newly appointed Chief Investment Officer, François Collet, outlines the main risks and opportunities he sees in global fixed income markets.

Do you think that fixed income's role will change?

Yes, it definitely has changed from a few years ago, but we believe that we can come back to our long position in the fixed income market. It has been a quite volatile environment for the past few years. It's been a quite negative environment, but should be much better going forward as central banks are cutting rates and as curves are much steeper than in the past.

What is your view on the US macroeconomic environment?

Growth is decelerating, not towards recession, but clearly decelerating. In the Biden administration years we had a large amount of immigration which fuelled a lot of US growth and that is clearly not the case anymore. Immigration is back to almost zero, which is lowering the supply of workers and so lowering growth. That is the main reason why US payrolls are cooling very quickly. Inflation is also running higher because of tariffs, which affects consumption and has a negative effect on growth.

And the Fed is not in the best situation, as it is losing on both of its mandates, so it needs to adjust toward much more neutral monetary policy. This cutting cycle is going to fuel long positioning on the fixed income market. As soon as the central bank is cutting, it's always better to have long exposure rather than short exposure. So, we believe that growth is the main reason why we should see low rates, but on the other hand we see inflation as kind of sticky, so that's why we tend to prefer inflation-linked bonds in the US rather than nominal bonds.

What is your view on European countries?

We see the outlook for Europe as quite bearish in terms of growth. We are stuck in a low-growth environment which shouldn't change in coming quarters. The fiscal plan in Germany won't start to have an effect before the second half of next year and at the same time we have recession risks in France. So, we tend to favour long positioning in European bonds, because we believe that the growth outlook is not so bright, having said that we believe it's very important to pick the right countries. We believe that Spain and Italy are the main opportunities because they offer quite a nice excess return over money market rates while providing a favourable fiscal outlook.

What about Asia, particularly with Japan taking a different tack on interest rates?

We tend to mainly focus on developed market countries, so some Asian countries are not in our investment universe, but when it comes to Japan we are clearly seeing a path toward higher rates from the Bank of Japan. Politics is playing an important role here, so we may see a delay in the next interest rate hike, but we know that Japan will continue its hiking cycle within the next few quarters as inflation is running higher than the central bank target and there is definitely a need for higher rates.

The Japanese curve is the steepest of all developed market curves. We believe that we should witness a flattening of the curve and so we prefer long exposure on the long end of the Japanese curve. 

Many commentators are saying it's now time to start extending duration. What do you think?

For once, I would agree, though I have been hearing that statement for a long time now. I heard that same statement a lot in 2022 from long only managers, who were saying that rates coming back at 2% or 2.5% in the US was an opportunity to buy, and I think that was not the case at all at the time.

But clearly, today, it’s an opportunity to buy fixed income.  We are seeing clouds on the horizon, stock markets and credit markets are priced very high, so we think that having long duration on government bonds is starting to be interesting. A lot of people are worried about fiscal policy and in some countries I totally agree that there is reason for caution, however in countries like the UK and Japan we believe these fears are overdone and it’s an interesting opportunity to buy duration and government bonds.

Now that we are seeing those opportunities in the fixed income market it’s time to add duration, but we also think that flexibility remains very important. In 2021 and 2022 for instance, if you were not able to be flexible you were not able to deliver a positive return. So we think it’s really important for fixed income managers, if they want to add value, to be flexible: to be able to pick the right countries and the right curve, at the right point of the curve.

How do you mitigate volatility?

The main way we mitigate volatility is through diversification, so it’s very important for us to have a very large investment universe.  That's why we look for investments in inflation linked bonds in the US, and government bonds in Italy, Spain, the UK, New Zealand, Japan and Australia.

At the same time, it’s important for us to be invested in highly liquid instruments because if we change our minds due to changes in the macro outlook or valuation, then we need to be able to react very quickly. That is why we have a higher risk budget for developed markets as they are by far the most liquid instruments. Whereas credit currencies, emerging markets and so on will always be a smaller part.

Which tail risks are you monitoring?

There are always tail risks in the fixed income market. One of them, which wouldn't be so much of a risk for us, would be to see a recession. That would clearly mean much lower rates, and I think would be positive for us. The main tail risk though is too large fiscal deficits, like in the US and France, so we are much more cautious on these countries.