Hello, and welcome to the Morningstar series,
“Why Should I Invest With You?” I’m Emma Wall and I’m joined today by Hermes’ Fraser Lundie
to talk about inflation. Hello, Fraser.
Hi. So, I don’t want to sound like a broken record
because last time you sat on that chair we talked about U.S. treasury bonds, but they
are, yet again, quite an interesting concept. Because there are increasing concerns about
inflation from some parts of the market and the impact this will have on the Fed and the
Fed’s decisions and the impact that will go on to have on the wider bond markets. So,
I suppose the first question is, are you concerned about inflation?
Well, as a credit guy, we are always concerned about everything. But I would say that the
signals being given by the treasury market right now are to some extent conflicting with
what you see in other markets, particularly on the equity side. You’ve the Feds intending
on raising rates several times in the next couple of years and yet, the long end of treasury
curves are telling you a different story with regards to long-term confidence in the economy
and some potential signals about the importance of stability around the dollar.
And you’ve seen certainly in the last few weeks in particular what a bit of dollar strength,
and I do say a bit because we are not far away from unchanged on the year now, has done
to the sentiment in the emerging market credit space. So, it really does underpin everything
which is why people like me are glued to inflation all day long.
And when you say you are glued to inflation, are there particular flags that you are looking
for, like, for example, the U.S. jobs figures we’ve had recently?
Yes. And we are also very focused right now on the oil market and other spot commodities.
We have big news this evening one way or other from Trump, I think, with regards to Iran.
And that is fueling potential inflation via the commodity market, but it’s also fueling
added geopolitical risk. And I think that is what is keeping us in this new volatility
regime that we are in since that volatility shock in the first quarter. It now seems that
we are not returning back to those very low, low levels for the foreseeable future. And
again, we need to price that in from a credit perspective.
And so, we are in this new environment, as you suggest. We are in an environment where
the Fed is making the raises that it suggested it will this year and volatility has returned.
So, how do you as a credit investor reflect that in your portfolio?
Well, I think, there is a lot of discussion around how late cycle we are or not in the
market right now. And I think that within credit it’s difficult to say that we are very
late cycle because of the sectoral makeup of the market. It tends to be a mixture of
very cyclical sectors, a lot of whom nearly died a couple of years ago in the energy crisis.
And then a lot of things that arguably are being disrupted right now, so healthcare,
autos, telecom, none of these sectors to me seem particularly late cycle. In fact, if
anything, they are behaving quite defensively. That’s a very different market to what’s going
on in equities, which is very tech-driven and therefore, quite shareholder-friendly.
So, from that perspective, I think, you are likely to get more attractive risk-adjusted
return than you might expect from cyclical credit today than maybe in previous cycles.
Having said that, covenant weakness is an issue for us. And I think that it has changed
the risk/rewards profile of low-quality credit essentially.
If you are going to get wrong though, because of the optionality being held so tightly by
the sponsors or indeed the companies, the lean that you have on assets or in fact, the
assets in the box when it really comes down to a default situation is likely to be a lot
lower in terms of recovery than you’ve seen in previous cycles.
And at the same time, convexity in the market right now remain pretty unattractive given
how short-called prices are. So, I think, it’s hard to argue that it’s a sensible time
in the market to be reaching down in credit quality. But I’m more than happy to take a
more pro-cyclical approach because as I mentioned earlier.
The other thing that makes me quite constructive right now is that we are still in a search
for yield environment because ultimately yields are pretty low, especially at the front end
of curves. And so, I think, there’s a lot to be said for making sure that you are optimizing
at what point in the curve you are accessing credit at. Because a lot of people seem to
be dipping their toe half in and they don’t really want to be there, which is understandable
because things are relatively expensive here as all markets are.
But if you are able to access credit longer out the curve without necessarily taking an
undue amount of interest rate risk, I think, that’s where the real opportunity is because
it’s kind of under-owned and the rolldown contribution to your carry is significant
here because curves are so steep. So, I would say that lending for longer to better quality
companies rather than shorter to lower quality should a mantra for this year.
Fraser, thank you very much. Thank you.