There is a need to adjust geographic and asset class exposure as the rates environment impacts markets, says Ismael García Puente (pictured), head of investments and fund selector at MAPFRE Gestión Patrimonial.
Here are his answers to key questions.
On rate cuts, the ECB did it in June, but what about the Fed? What is the scenario now?
It's hard to get out of the vicious circle that central banks have gotten themselves into by making their monetary policy decisions totally dependent on macroeconomic data just at the worst time. Yes, it’s always been tricky to make macro predictions, but now, following the pandemic, it’s even more so:
• Growth has been sharply affected by supply-side changes
• Inflation dynamics have upended all the assumptions they relied on until the pandemic.
• The reaction function of the central banks themselves has been erratic.
Given all this, we think it makes sense for the Fed to put off its first rate cut until September, as growth remains solid, inflation is converging more slowly on the target than they would like, and barring elevated real interest rates, I don't think there is a need to cut rates.
One thing that has started to change recently is the labour market: whoever wants to – because this is a very clear confirmation bias – has already begun to spot in the employment data and in the labour market the initial signs of weakness by resorting to the Sahm Rule, which predicts a recession when the unemployment rate has risen 0.5% from 12-month lows.
According to recent data, unemployment increased by 0.3 percentage points from the March 2023 low of 3.5% to 3.8%. If unemployment continues to rise, that’s when I think the Fed could indeed move forward on its path to cutting real interest rates.
For the ECB, I think it makes much more sense to start cutting rates because the inflation we have been experiencing was more supply-side inflation than demand-side inflation, and it’s been cooling. In addition, real interest rates had barely became positive and we've already seen the slowdown that this meant for some economies. And in Europe, households and companies have a higher percentage of debt at revisable rates than in the USA, where fixed-rate financing predominates, so keeping rates high for longer would cause more pain.
Now, this is where the debate comes in as to whether the ECB would do well to pre-empt the Fed with a very aggressive rate cut program, and what the implications would be for the dollar.
Here again, we can find all manner of opinions: there are those who believe that rate cuts would be negative for the euro, causing inflation to rise, and that Lagarde would have made the same mistake as Trichet. However, if you read analysis from an economic point of view and not from a market point of view, you will find the opposite argument, given that only 9% of total eurozone imports come from outside and more than half of imports are in euros, which has led the ECB's own research service to conclude that a 10% depreciation would result in an increase in inflation of 0.4% the following year.
On geographic areas, we often say that this is Europe's year, but it ultimately has a hard time standing up to the US. Is this the year?
The conditions are in place because, on the one hand, the macro picture seems to be improving according to the leading indicator readings we have been getting over the last few weeks, valuations are starting from relatively low levels and we may see higher corporate earnings growth than expected at the start of the year. But it still seems to me that this earnings growth is not big enough to outpace what we would expect from the United States, which also, given the mix of companies listed there, deserves a higher valuation premium.
On fixed income, it has yet to get off the ground. In which segments are you seeing value?
The scenario we envision is this: the fiscal momentum will remain positive, which will neutralise monetary policy from negative to at least neutral, which is supportive for growth and risk assets.
The Fed won’t be able to cut rates more than twice, barring a financial accident, and we will see whether the ECB's path, which began in June, has much room for manoeuvre or not, along with that of other central banks such as Sweden, Switzerland, the Bank of England or the Bank of Japan itself, which will probably continue to bring a lot of volatility to fixed income.
So, we will likely have a fixed income market with higher dispersion/volatility, along with a gradual increase in credit risk, although for the time being, these would be isolated cases.
If we look at interest rate levels, we must admit that they are attractive and could meet the target returns of many more prudent portfolios without having to take on too much risk. For portfolios where the targets are higher, we’ve been applying a “barbell” strategy since last year: we take on moderate credit risk at the short end to get the famous carry, and start increasing duration towards the middle with both government and corporate bonds if duration starts to help.
At the asset level, it’s hard to see any opportunities with spreads as tight as they are. We recently unwound a large position in subordinated bank debt which performed extremely well (not without some hiccups) and in high yield we do not see much upside beyond the possibility of an early call on many bonds if interest rates fall and issuers can get cheaper refinancing.
So, rather than having directional bets on fixed income assets, we’re delegating a good part of the fixed income portfolios to active and flexible managers who use exposures to different assets to achieve an IRR/Duration/Credit Risk triangle that is superior to what we can find by betting only on a single asset.
TIPs, Covered Bonds and Single A long-duration bonds are niche markets where our managers find value.
As rates fall, money market funds will become less attractive. In the meantime, the uptake in Spain has been huge. What is your view on this?
We're aware of this and we have to make our clients aware of it, but I won’t be the one to demonise money market funds.
I see them as a better option that’s much safer and more profitable than deposits, so I think it’s a good idea for the conservative investor to keep part of their assets in money market funds. It’s a step, a small one, but it is a step towards improving the quality of clients’ portfolios.
In addition, liquidity has always been part of asset allocation decisions for institutional investors. With positive returns, they still seem to me to be the cheapest downside hedge available. That’s why I’m not surprised that they continue to capture a large part of the net underwriting, as is also the case in the United States. That is, this isn’t unique to Spain.
Here the ideal, as I said at the beginning, is to make the client see that they can’t have a high percentage of their portfolio in money market funds, but that there are other assets that can benefit from the low interest rate environment. But how can you make them see this after you’ve been constantly talking about recession, then there’s no recession and you have a bad 2022 in mixed portfolios, and they have to increase their risk level? That’s a task that only the best financial agents will be able to perform well.
By Ismael García Puente, head of investments and fund selector at MAPFRE Gestión Patrimonial
