Fixed-income investment strategies in the age of the New Normal

I came across an interesting presentation given by one of the senior members of PIMCO UK, a chap called Mike Amey.

Click here to see it (a PDF).

What I especially like about this presentation is that it covers a lot of the main topics that I hear investors discussing at the moment, ranging from the bigger themes like EMs vs developed markets or the general Health of Economies, global inflation, tail risk, through to the more technical strategies like carry.

In this post I give background and thoughts on some of the topics and terms that Mr Amey uses in his presentation.

Background & comments on the topics covered

GDP

Mr Amey’s chart on page 3 compares how GDP has evolved after previous financial crises. He compares GDP progress after the peaks-just-before-a-crash; here is some background on each of the recessions he is referring to:

• Q4 1973: Oil crisis (Oct73), end of the Bretton Woods system, end of the post-WWII boom. Most Western economies were affected by this ‘stagflation’ recession. After the oil shock, inflation more than doubled from a previously stable 3%-ish annual rate to around 8%, then reaching near 10% in 1975. By 1979 inflation was at 11% and touched 13.5% in 1980.
• Q1 1980: Second oil crisis (79), inflation at high levels, stagflation comes back to hurt the US economy. Policy action by the FED to contract the money supply helped bring inflation back to 3% levels by 1983 (the FED funds rate was at 20% in June 1981). Other key stories in this period:
  • Many banks failed (deregulation in 1980 set this up).
  • Savings & Loans crisis.
  • Reagan elected in 1981.
• Q3 1990: Black Monday (19th October 1987), ~25% fall in US & UK equity markets. Initially recovered from, but contagion brought big problems to the Savings & Loans industry in the US. The pain started to become more apparent by about 1990 as the economy slumped, not really recovering until about 1995.
• Q2 2001: Dot com crash.
• Q1 2008: You know this one.

I’ve seen this kind of comparison used by plenty of analysts to put a perspective on the current crisis.

Looks bad, right? Makes you wonder why the stock markets are rallying back to their pre-08 highs (and that question is frequently discussed in the financial press).

Emerging Markets vs Developed Markets

Slides 4, 5 and 6 compare statistics for developed markets with the same statistics for emerging markets (EMs): public debt, spreads, unemployment.

The story of EMs versus developed countries is typically one of growth potential.

The rule-of-thumb is that companies cannot on average grow more quickly than the economy, and conversely an economy cannot grow more quickly on average than its businesses. Developed economies have fewer opportunities for new companies to have a big impact, so it follows that you want to buy stocks that will grow quickly, you need to start looking at the economies that will grow more quickly because they are developing.

That’s the spirit of the notion, at least. The conclusion that fund managers arrive at is pretty clear: invest a proportion of your portfolio in EMs.

The same EM theme also underlies the increased number of funds and investment strategies which use the term ‘Global’. In this sense ‘global’ means ‘including places which are not your usual hangouts’, ie EMs. You might argue that global includes China (the big growth story of the moment), whereas emerging may sometimes not.

There have been plenty of news articles and commentaries in the papers on the ‘EM story’.

Back in Jan12 I was reading reports in the FT that asset managers were continuing to open ‘global’ funds. There have been a string of commentary articles in the FT which have argued that the best and safest way to get exposure to EMs is to invest in global companies that are growing their businesses into EMs, since you get the security of putting your money into a mature company and are protected to some extent from the volatility or uncertainty inherent in direct investing in EM companies.

Interestingly, on slide 11 Mr Amey shows how (in the realm of fixed-income investing) EMs were previously seen in terms of credit risk whilst DMs were considered as interest-rate risk. But in the New Normal we have plenty of credit risk in DMs too, so Mr Amey proposes a new visual for EMs & DMs.

Public vs Private Debt

One of the key discoveries of this crisis is that we need to keep our eyes on the amount of private debt in our system, and not just on the amount of government debt – since when defaults happen, meaning that private companies and families cannot pay their debts, then the government has to step in to stop the whole system from collapsing.

Therefore, Mr Amey’s chart on slide 4 is just emphasizing the difference between the conditions of the EMs and the DMs: the western markets are in the process of deleveraging, and defaulting, and the governments are having to support their markets by taking on more debt.

Cyclical vs Secular

These terms are just a fancy way of saying short- or long-term:

cyclical = short term,

secular = long term.

Curve steepness and carry

On page 12 Mr Amey introduces the idea of carry-based investing.

I have written a short post previously on carry (click here). Carry is a concept which impacts your profitability if you are using leverage in a fund: ie you are using debt to leverage up your returns (& losses too), so for each GBP1m you use from your fund you may borrow another GBP1m and effectively double up your returns or loss.

If you are not using borrowings to fund your investments, then carry would not directly impact your earnings. But it can be used as an answer to a question like: how much will my investment be worth in n months time if the world remains unchanged.

In this sense, ‘carry’ is a bit like ‘expected return net of costs’.

Loosely, if someone says ‘good carry’ they may simply mean ‘probably profitable’, or ‘robust’. That’s fair enough, I think.