While the fourth quarter of last year may have signalled the end of the bull market for some investors, Hermes Investment Management’s Andrew Jackson said there were some signs of resilience in the fixed income space.
Although much appeared to change during the last three months of 2018 — as the US yield curve briefly inverted, price-to-earnings (P/E) multiples collapsed and markets sold off — at a more fundamental level there were fewer developments on longstanding issues troubling the markets.
Jackson, head of fixed income at Hermes, noted that the Brexit outcome was still unknown, the European political backdrop was still unclear and the rise of protectionism continues to weigh heavily on global growth.
“Some of the more effusive commentators variously described Q4 as a catastrophe and a blood bath,” he said. “This has left many investors scratching their heads as to what exactly has changed.
“My short answer is that nothing actually changed: we just noticed that the emperor was somewhat under-dressed. But it could have been much worse.”
While high yield spreads have widened in tandem with falls in the S&P 500 since September 2009, that relationship was more muted during the tough market conditions of Q4 2018.
Performance of indices during Q4
Source: FE Analytics
Jackson said the fourth quarter could have been much worse, particularly as the market moves into the latter stages of the cycle.
“The signs that we are emerging from an end to quantitative easing happen to coincide with rising protectionism and uncharted geopolitical territory as US-China tensions increase,” he said. “Simultaneously, end-of-market-cycle conditions are on the horizon.
“Given all that, we should perhaps be relieved that the sell-off in Q4 was so mild and that the recovery has been relatively broad-based and rapid.”
However, the Hermes fixed income head said “some scar tissue has been created” and noted that investor positioning would likely be cautious for some time to come.
Such scar tissue can be found among UK assets, which the firm continues to tactically underweight despite a ‘Brexit premium’ compared with other long-run holdings.
While there were relatively few big changes to justify the pessimism around markets, Jackson said there had been some nuanced shifts in the asset class.
The first shift has been seen with the shrinking of the illiquidity premium, said the Hermes bond specialist.
Holders expecting to earn a premium on illiquid assets relative to their more tradeable counterparts will have been left disappointed more recently.
“Liquid markets depress asset prices — or widen spreads — and, to start with, these movements are not quickly reflected in private and less-liquid parts of the fixed income market,” he explained.
“Only the passage of time or a further deterioration in liquid markets triggers a repricing in the illiquid spaces, but this is often a rather violent correction when it does occur.”
As such, he said there was real value to be found in the more liquid parts of the market, particularly in the more defensive areas.
Another shift that Jackson said had gone broadly unreported was the meaningful outperformance of emerging market credit during the final quarter of the year.
While some of this came after a particularly challenging third quarter, Jackson said it highlighted the benefit of a flexible approach to allocation.
Performance of indices during Q4
Source: FE Analytics
“Broadly speaking, our view on emerging market credit is that it should not be seen through the same lens as emerging market equities even though it suffers from many of the same issues in terms of end-client flows,” he said.
As the above chart shows, the MSCI Emerging Markets index fell by 5.26 per cent during the fourth quarter — in sterling terms — while the JPM GBI-EM Global Composite made a return of 4.93 per cent.
As a result, the Hemes fixed income head favours emerging markets over the European and US high yield markets.
Despite the environment for fixed income being less pessimistic than has been reported, Jackson said Hemes continues to advocate greater caution.
“Now, more than at any time over the last few years, we believe caution and discipline in terms of individual name and security selection will be valuable,” he explained.
The amount of tail risks remain considerable but, likewise, investors should not panic during sell-offs, he said, noting that the ability to hold on to positions can be very helpful in the long term.
“Given the strength of the early-2019 rally, participating in the beta of the market and, in particular, holding some of the positions that were most hurt in Q4, would have been hugely advantageous, particularly if it were possible to ‘trade’ some of those positions through the volatility,” he explained.
Performance of indices over 6mths
Source: FE Analytics
In addition, Hermes’ Jackson said he does not foresee a huge reduction in the tail risks facing the fixed income market and long-term fundamental issues remains unchanged.
“We think it is vital to caution that this sell-off was not the big one; at no time during the sell-off did I feel that it represented anything more significant than a slight correction in the huge bull run that has endured far too long,” he said.
“Our equity colleagues saw much worse than we experienced but, with the utmost respect, I feel that there were a few very obvious bubbles out there that needed to deflate a little. They have, and we feel that markets are more balanced as a result.”
Concluding, Jackson said the firm continued to hold a meaningful net long position in credit, adding: “Higher all-in yields make credit a more attractive long-term investment at these levels and, given that global growth is likely to be sluggish, we see the medium-term picture for fund flows into credit as positive.”