I sat down with Kirstie Spence and Haran Karunakaran from Capital Group last week to discuss current markets, asset allocation and how they build resilient portfolios.
EM – What’s your key message to clients on this trip?
KS – It’s a combination of things. Conversations include fixed income being back in vogue with yields rising. Also, how to think about fixed income in an inflationary world. Being able to offer breadth and diversification in fixed income portfolios through channels like emerging markets, which has evolved and changed so much, which is my world, can be so helpful.
EM – Okay, what’s your base case for interest rates and inflation right now?
KS – We are asking ourselves what are the potential longer term growth impacts and the longer term inflation impacts? It’s complicated this time because we already had the AI, secular potential tailwinds on growth and disinflationary forces. And now we’ve got these geopolitical, more inflationary ones.
We land in a slightly suboptimal, but kind of more neutral outlook where you don’t take too much of a position right now.
The duration of the war was the key thing we were focused on early on. Whereas now I think it’s a lot about where trade levels up, what does and doesn’t flow and how it kind of evolves over the next six to nine months now that it looks like we’re through that immediate escalation part.
I think inflation is foremost in most central banks minds and we’ll go back to the growth dynamic.
But it’s messy. It’s probably a bit more of a headwind on growth. This is my opinion, not the house view, and I think it is a more inflationary environment.
And so, I think you get rates going up a little bit more in the short end and then you probably get more kind of fiscal risk and growth risk priced into the long end of yield curve.
Also, as an emerging market investor, significant volatility is how we thrive, and it’s also kind of how we’ve made our reputations.
EM – I know you’re based in the UK. Do you have an outlook for the UK and Australia and how that might differ to the US?
KS – There’s generally more propensity for central banks to raise rates. In the UK, we feel completely flat on the rate outlook. In the US you’re pricing out the cuts, but if anything, you might lean towards easing. And so, the outlook is mixed and sort of a bit stuck in the middle. One is more likely to hike, one more likely to stay flat, one more likely to ease, I think. But yeah, the UK I think has, I would argue, more of a growth challenge.
And so, I think that that sort of holds down rates a little bit more.
HK – The sensitivity of energy prices is a bit higher in the UK. So, there, our analysts have shifted from an overweight duration view to more of a neutral duration view. The expectation that probably the first step of the BOE will be saying publicly no cuts.
And then as a next step, maybe later in the year or into next year, considering hikes, if energy prices stay very sustained. But interestingly, I think the US really stands out in global markets as one where the pressure to hike is much less, partly due to some of the fragilities in the economy. It’s got this AI engine driving growth, but underneath that, there’s kind of fragility in the labor market. The Fed is watching. In our Australian domiciled portfolio, our multi-sector credit fund, we actually added duration in the US last month taking advantage of the sell off in rates.
EM – One of Capital Group’s themes seems to be having a resilient portfolio. I’m wondering, what does a resilient portfolio look like at the moment?
KS – So, we do a thing within fixed income called Portfolio Strategy Group, which a couple of times a year we get together and we try and look at all the asset classes within fixed income. We don’t set binding rules for portfolio construction, but we give guidance for what a risk managed portfolio would look like for the macro environment that we expect.
But I think what’s great about doing that is its long term in focus. The other thing about it is that it is research driven like everything we do and our macro group, capital strategy research, they feed in a lot of that macro work. And there are political, geopolitical and economic analysts within that.
They use a quadrant scenario framework, which has been incredibly helpful for trying to think through the escalation versus non-escalation of the war and then the quick conflict versus not quick conflict. So, when you put all that together we were able to start seeing the impact of shipping and all the other issues that were going on within the war.
We realised you can’t go completely risk off because the nature of the conflict, both where it’s emanated from and the way it’s manifesting isn’t one of those where you say just raise loads of dollars and raise lots of cash and wait for the big sell off and then buy back in. So, the overall recommendation is this quite balanced portfolio of risk that leans into things like, a little more duration where you’ve probably got that propensity for lower growth in the shorter term and perhaps taking out some of the overheating from AI.
When you look at the balance sheet, and analyse companies, they’re perhaps in better shape than government debt right now. And so, having a highly diverse, diversified portfolio of credit risk that’s not super overweight, but still maintains some exposure, gives you that income, is fairly sensible.
And similarly with emerging markets, it can actually offer a way of getting exposure to different themes, different regions, different sectors. So, we try and think about that long term, put it together in a balanced way. And then I think always the goal is let’s then look at it overall, how it works together, mitigate the unintended risks we might have in there and try and really take those active risks.
The real message is longer term diversified, resilient in terms of cash flows, resilient in government’s ability to fund and pay, but don’t go no risk.
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HK – We’ve been underweight high yield in the credit fund since 2021, and for the first time we are slightly overweight now. And it kind of makes it counterintuitive, why would you add high yield credit at a time when there’s a lot of uncertainty involved? But to Kirstie’s point, it reflects a change in the structure of high yield markets, which have become much higher quality, much lower duration as well.
High yield used to be a four and a half year duration asset class, now it’s under three years, so that’s quite a change. And as a result, the resilience or defensive properties are much stronger.
EM – What tools do you use to combat inflation in your portfolios?
KS – A good example of thinking is do you really want the longer duration sectors of fixed income in this kind of environment, or can you keep yields and go shorter? We do use inflation linked bonds obviously in the government and rates portfolios. At the moment, I wouldn’t say they’re particularly good value.
There are certain sectors that feel more inflation protected. So, you might see some rotation into corporate bonds sectors that are more resilient in this kind of environment.
That’s one of the beauties I think of having corporate bonds in a multi-asset portfolio is you can manifest a different set of themes, whether it’s importers versus exporters, or domestic demand versus something that’s more to do with trade, or energy versus utilities. There are ways of taking these macro dynamics and saying, “Okay, what are some of the ways that we can reflect that those changing micro trends?”
HK – So, inflation could go up, growth could come down, but it’s probably not going to be a repeat of 2022 where you get 500 basis points of rate hikes from central banks.
EM – Yield curves are flattening and you have always favoured duration, Haran. Are you still topping up duration at this point?
HK – We do have a view that particularly for credit portfolios, having a moderate amount of duration provides balance and diversification. Is this the time to be taking a huge amount of duration risk? No, we are not out there adding five to 10 years of duration. But on the margin, I think we have added a bit of duration, simply taking advantage of extreme movements in March where you flipped from a market that was pricing in two to three rate cuts in the US to pricing rate hikes within a week.
EM – Kirstie, can you talk a little bit about emerging markets and why investors should reconsider investing if they haven’t already?
KS – I’ve been investing in EM for 30 years, which is basically the length of the asset class. It is dramatically different today versus what it was years ago. The whole point of emerging markets was how do developing countries fund themselves for development. And originally, it was done through hard currency borrowing and that comes with risks.
Over time, you hope that countries get to a point of development and credibility on the interplay between monetary, fiscal and economic policy, that they can also issue their own local currency debt and build yield curves. And that’s what you want as a country, obviously, because it’s safer. It provides your savings platform with something to invest in, and it gives your banks and your creditors something to wholesale lend from domestically. Countries don’t default on domestic debt, they just print more or devalue their currencies. So, that’s the evolution that we’ve been seeing for several years.
And I think that is underestimated often in the market because people tend to think of an older narrative of default, or they just get big currency moves and it wipes out all of your return. But we talk a lot about this widening of the market, so the number of countries involved. I mean, I think the most we’ve ever had in our portfolios is 70. Particularly in the last five years, we have seen the ability to diversify, but also the independence and the resilience of a lot of these economies, particularly the ones with their own local markets.
If countries can’t credibly manage inflation and can’t credibly borrow domestically, then they’re not going to make it as an economy. Governments will get ousted by voters. So, governments really care about inflation as do voters. It matters hugely because for a lot of them, food and energy and inflation are even more important than for us in the developed world. What we’ve seen in the last five years is quite a healthy resilience and a focus on their own domestic policies.
With the current crisis, we saw resistance to just fiscally pumping up the economies in the way the developed world did, because they couldn’t afford it. It just doesn’t work in economies that tend to have jobs that can be more cash in hand and short duration. We also saw a very proactive reaction to the inflation cycle, whereas we did not necessarily see that in the developed markets.
You’ve got really good valuations and economies were quite primed for cuts because they had gone over the hump of dealing with inflation and they were ready to cut to start supporting the economies. As soon as the war started, most of them stopped their cutting cycles. They just got priced out and I think, that is a sign of credibility.
Emerging markets is the one sub sector that isn’t particularly overvalued, seems to have decent fundamentals including debt levels, manageable inflation, reasonable fiscal deficits, and valuations that are quite attractive.
Which areas? The one that has been most interesting in the last couple of years has been Latin America, not only because the nominal yield levels are high. So, whether it’s 12% in Columbia or 7-8% in Mexico, real yields are high and you’ve had governments proactively managing both fiscal spending and inflation. Some of that has come from the world getting a little less global and a little bit more independent and a bit less caring.
Latin America is the obvious region. You don’t necessarily make it your whole portfolio. It’s going to be more volatile, and it is going to get driven by political and fiscal headlines, but having some in a broad fixed income portfolio, not as some tactical month in month out, but strategically makes a ton of sense.
Central Europe’s been really interesting as well because you get similar dynamics to Europe. You’ve got the fiscal pressure on defence and also got growth.
And then Asia’s really interesting too from a diversification perspective because it’s really all about Chinese growth and then how that manifests. And then you’ve seen these changing trade relationships and the changing sector dynamics from China and the Chinese demand. And so, emerging markets offers the ability to invest around a number of different long term themes in a really diversified way with higher yields.
The market is a much more resilient and mature than it used to be.
EM – What sort of allocation would you have to emerging markets in a multi-sector asset portfolio? What is your allocation?
HK – So, in our multi-sector credit portfolio, the neutral point is 15%. That is what we’d expect over time, but we certainly go a bit higher when spreads look relatively attractive versus the other asset class and sometimes it’s a bit lower. But I think to Kirstie’s point, the key thing we’ve found is having that structural allocation in there is really helpful from a diversification perspective.
KS – To be really clear, in multi-sector, it’s more the hard currency element of EM. So, it doesn’t necessarily play into as much of those inflation and real rate dynamics. Right now, the lean to high yield brings your duration shorter.
EM – Why should potential clients come to Capital Group? What do you offer? What makes you different?
KS – We are founded on research, and I think there’s a lot of asset managers out there where that fundamental focus on research has gotten a little lost. It’s highly collaborative research. So, my EMD team, for example, are working with their equity counterparts, with their high yield counterparts, with the macro analysts to try to get those really robust insights that are durable over the long term. And then the long term is key.
We’re compensated on eight, five, three and one year numbers.
And finally, we have a lot of different perspectives. These are the three pillars our investment approach.
In addition to that, just for a hundred years of investing, we’re a private company, we’re not distracted by anything else. We only do one thing. We have such a simple mission, improve people’s lives through successful investing. It’s just that basic.
Background
Kirstie Spence sits on the Capital Group Management Committee and this trip was part of a very broad effort that they call ‘Leadership Week’ across the region. For the last couple of years, the team has a board meeting abroad, which they tie in with operations committee and other leadership groups. Last year, they were in California and this year they were in Asia. Members make side trips around the region, then back in Singapore for the actual board meetings. It’s helps make sure the team is aligned on long-term strategy.
