The big decisions - three key areas of focus in the Invesco Global Income Fund

As an active fund manager, I always have a number of things to think about. But, perhaps the main three are as follows:

1. Where is performance going to come from? 
2. What risks have I not thought about?
3. Is my positioning right for this environment?

In the below, I discuss the key considerations that are at the forefront of my thinking and decision-making.

Inflation buffers

The biggest headache at the moment is the possibility of a pronounced sell-off in government bonds, which could reset the tone for risk markets. Given the weak yields we’ve seen, I’ve maintained low duration risk within the fund. 

So far, it has been the case of the dog that has not barked, and yields have not risen materially. However, ever-higher inflation prints in the US have been catching my eye and there is a growing sense that inflation is less transitory than the US Federal Reserve was suggesting. This may lead to US rate hikes soon.

Figures 1, 2 and 3 below support this area of concern. Figure 1 shows that inflation is no longer driven by outliers. Trimmed mean CPI – which removes outliers from each end of the distribution – jumped to its highest level in three decades.

In Figure 2, the Atlanta Fed separates out ‘sticky’ and ‘non-sticky’ inflation. In October, sticky inflation had its largest increase since January 1991.

US Federal Reserve members have often said that inflation is still low, if you exclude one-offs such as used cars, energy and food. Unfortunately, this is no longer the case. If you exclude shelter, food, energy and used cars and trucks, CPI is running at around 4% currently (Figure 3). 

In general, the predictive power of past inflation is quite weak and economists believe that inflation expectations drive how inflation behaves in the future. The longer the current bout of inflation lingers, the greater the likelihood of it morphing into a longer-term issue. This in turn has the potential to impact future inflation as it embeds itself into expectations of consumers and businesses.

Here you can see how inflation expectations are starting to pick up. Figure 4 shows market-driven levels – the US 5- and 10-year inflation expectations. Figure 5 shows the survey-based expectations, broken down by demographics. 

On the other side of the coin, betting too hard against central banks has been a widow-maker trade for many investors in recent years, so I don’t want the low duration position to be a ‘make or break’ feature. It’s something I can manage actively. However, it will take a pronounced increase in yields for me to substantially change my low duration strategy.

This view of inflation risk leaves me happy to continue holding equites (currently 50% of the fund including derivatives exposure) which we think will deliver better returns than bonds in an inflationary environment. While I worry about what a sharp rise in interest rates may do to risk assets with rich valuations, for the time being, this is not the most likely outcome in my judgement. Our equity exposure is well-diversified and balanced with less sensitivity to interest rate rises than the market. 

Generating income from emerging markets

It might seem strange for me to be thinking about emerging markets having just argued that US interest rates are likely to rise from this point. After all, higher US rates and a stronger US dollar have often been the signal of challenging periods for emerging markets.

However, if as a portfolio manager you think about all the things that could go wrong, you risk talking yourself out of doing anything with the portfolio at all. So, although I am aware of the potentially difficult backdrop, there are still yields out there that are big enough to pique my interest. I am also comforted by the fact that emerging markets often enjoy strong external balances and expanding local investor bases.

I should also explain that, for me, finding yield in emerging markets is not about a wholesale asset allocation shift, but instead a very selective approach. More spear-fisher than trawler. In recent weeks I have bought small positions in Nigeria, Egypt and Ukraine, among others. I am getting paid mid-7% yields on these bonds which is a fair reward for the risk in my view.

Of course, I expect these bonds to move around a bit. Indeed, they are all a bit weaker since I bought them. But, all things considered, I believe they have a good medium-term return profiles.

The bonds I mentioned are denominated in US dollars and, as such, the currency volatility has no impact on the expected returns. However, there are some countries that are way ahead of the Federal Reserve in their tightening cycles. For example, Russia and Brazil have increased their base interest rates significantly and we are getting paid higher interest rates in the local currency that offer us a cushion for currency volatility. I do not think a well-telegraphed and measured Fed tightening cycle will have a significantly negative impact on these rates and currencies.

When to back out of high yield and subordinated financials

What to do with the overall level of high yield credit risk has been a real dilemma for me. I need to generate income but taking duration risk doesn’t get me there. Equities can certainly contribute but credit risk is a key part of this income-oriented strategy and I need to have some exposure. 

Furthermore, the feedback from our team’s credit analysts about general corporate performance is pretty sanguine at the moment. This month, there have been a raft of quarterly results with many companies reporting good or better than expected results – M&S, the UK retailer, Coty (beauty products), Darling Ingredients, Refresco (beverage bottler), British Land, Bayer and Schaeffler, to name a few.

Set against that are the low yields. My starting point is that the fundamentals are strong, but the price upside is somewhat limited. As a result, I have relatively modest levels of exposure in the portfolio (high yield corporates constitute 14% of the fund). However, I am also reluctant to exit entirely because they still produce income and there is little by way of credit risk for me to worry about.

Part of the income is drawn from subordinated bonds (higher risk) of financial institutions, like banks and insurance companies. These have embedded equity-like features but behave like bonds in benign market conditions. So far, our exposure has performed well. It feels to me that there is very little upside in price, as is the case with high-yield bonds, but we can continue to receive coupons.

Defensive duration, long equity

As you can see, I am defensive in duration but happy to maintain our long equity risk so long as US interest rates don’t rise too rapidly. For the time being I think the portfolio is well-placed for a steadily rising yield environment, but I will be watching inflation data and the Fed’s reaction to it.

In credit, I am moving very selectively in emerging markets where we can find some decent yields but am keeping my high yield component quite conservative. I am still constructive on our bank exposures and will be watching risk and reward between bonds and equity in the coming year.

I’ll leave my equity position intact, while closely watching valuations and volatility.