EDITED TRANSCRIPT
Lukasz de Pourbaix (LDP): Hello, my name is Lukasz de Pourbaix and I'm pleased to welcome Harry Hardy, Investment Director for the Fidelity Global Bond Fund, all the way from London.
Fidelity has been in the bond business for over 35 years and we're very excited to talk about all things bonds to get today. Welcome, Harry.
Harry Hardy (HH): Thank you for having me.
LDP: Many people out there won't realise that the bond is much bigger than the equity market yet it sometimes it falls under the radar. If we think about markets over the last couple of years a lot of the action has been in the bond market and particularly more recently with tariff announcements from the US and Liberation Day, we've seen bonds become a lot more prominent in terms of the news.
Can you take us through some of the key macroeconomic issues that we've seen over the last couple of years impacting bonds?
HH: After the Global Financial Crisis, we had the quantitative easing (QE) phase, so things were a little bit tamer in that environment. But with COVID, really loose monetary policy and QE were in overdrive at that point. That led to an inflationary spike. The US Federal Reserve (Fed) was a little bit behind the curve. They, for a long time felt that inflation would be transitory. Obviously, that was misjudged and as we all know with the benefit of hindsight, that really wasn't the case. So, we had quite an aggressive hiking cycle in that 2022 -2023 era, a spike in bond yields, which was quite painful for many bond investors at that point. Obviously, at that juncture, we got to a higher starting point in terms of yields. This has resulted in a pickup in client interest and demand for fixed income assets post that point.
Recently too, we've got to an eventful juncture with the tariff announcements post Liberation Day, so April was particularly challenging. We had huge volatility in the bond market. The 10-year oscillated from 380 to up to 460! An 80 basis point swing. But I think what's quite important, with context, is that if you look at the moves over the month, it really wasn't that severe at all. If you're on a desert island somewhere and just looked at the last business day of March and the last business day of April, it was not a huge move on the tenure. Obviously, there was different parts of the curve where the moves were more pronounced. But I think context is really important. I think where we are today is still an attractive point from a yield perspective and that global fixed income does provide a buffer to one's portfolio.
LDP: I think that's a really valid comment because a lot of investors of the last couple of years where they've seen volatility have also seen bonds not necessarily adding that buffer, but we are seeing that come to the fore at the moment.
If we think about the tariffs; as an active manager, we've got a very active and concentrated strategy that can be quite contrarian at certain points in the market. How do you navigate this environment?
HH: What's probably an interesting start to respond to that question, is if we flash back to the days after Liberation Day and what our views were. Obviously, this is somewhat stale now because we've had that 90-day pause and we don't know where we're going to go from here, but in the real aftermath a lot of our focus was on China tariffs specifically, whilst tariffs more broadly were at our forefront.
The level of tariffs that we saw imposed on China, which peaked at 145%, was a real topic of concern for us. In our view at the time, that was not a level that we felt the world economy could function at. So, we were very much in the camp at that time that there was going to be a slowdown, that was going to weigh on growth, the demand for employees, labour going forward was going to be stretched on that front.
Obviously, that's changed a little bit. But what we did from an active management perspective is that we took a long-standing position in the Fund to be long duration predominantly in the US. We took the opportunity where we had that rallying yields not quite at the bottom, but in the low force to trim our duration position there to lock in some profits to capture some alpha.
If we look at some of our other duration position, we had an underway in Japanese government bonds for some time as well. We had a sharp rally following the Liberation Day events and we took that opportunity once again to increase that underweight position, to take advantage of the moves and that's been quite a positive alpha driver since Liberation Day.
We've been nimble, we've been active.
Where we were a little bit more cautious, is our long-standing underweight credit risk position in the Fund. That's largely been centred around valuations which are quite stretched. If we zoom into US investment grade (IG) credit, we're with hit points this year where spreads have been at the tightest they've been since 1998. When you reconcile that against our top down view of a struggling US consumer, potentially the Fed having to maybe do a little bit more than the market expects, that's our odds.
We did have that widening, we did have that sell off in credit spreads post Liberation Day, but we really did not see that at the time as an all-out buying opportunity. In that context, we maintain a defensive credit bias, but we try to do a little bit more beneath the hood, so to speak: Trying to capture a little bit of alpha from a bottom-up perspective, working with our analysts to see 'has this name just been indiscriminately oversold along with everything else and taking those opportunities to top up some of those positions?'
To be transparent, we've been a little bit early on our underweight credit position. We've had that for much of 2024. If we flash back to the back end of 2023, we had a long credit position there. We trimmed that position.
If we flash back to January of 2024, US IG credit spreads did not compensate for the risks associated to our top-down picture that we had built. We've maintained that position. We were a little bit early once again on that. Credit spreads have continued to tighten. When we were coming into this year, we have maintained that position.
Coming back to some of those contrarian views we did receive quite a lot of challenge on that. In the Liberation Day event, we did widen in some issuers by 30-40 basis points, but once again, with all the unknowns ahead, we just didn't feel that that was an appropriate time to really dial up risk in the portfolio. What we did try to do is see if there was a name that we felt had been a little bit overblown. We did top up and positions in some select auto's names, which we felt were less tariff focused.
That's really been the focus, trying to really position the portfolio from a bottom-up perspective.
LDP: A lot of recent conversation has been around interest rates, particularly in the US: will the Fed cut? If so, to what extent?
Over the last 12 months, there's been a variety of views ranging from maybe just a couple of cuts through to maybe four more cuts. What's your view?
HH: If we're looking at the current market pricing for Fed's funds cuts, it's around two cuts. That is broadly in line with what we see from our base scenario.
I think what's actually more interesting and more topical, and I believe that many investors are overlooking this at the moment, is that in a risk-off scenario, so in a scenario whereby we do have a slowdown in the US or we do enter a recession, we feel that the Fed's going to have to cut far more aggressively than what's being priced at the moment. So that could even hit around 200 basis points of cuts.
The reason why we have this view is if we look at the mortgage composition in the US marketplace now, our view is that the transition mechanism has extended considerably. The reason being is that 75% of US households have a fixed rate mortgage of 5% or lower. If we look at the current market pricing, even including 100 basis points of cuts that the Fed did last year, those mortgage rates are in the late 6%s, in some instances touching on 7%. If the Fed does need to stimulate the real economy, it will have to do far, far more than the market is pricing.
We also then take a step back. Most Americans are employed by small to medium-sized enterprises. US IG credit spreads are particularly tight, so if you're an Apple, Microsoft, Meta, etc., your funding costs are relatively quite loose. If you're one of these small to medium-sized enterprises who's reliant on bank financing, private lending, etc., your rates are around 9% currently.
So, once again, despite those 100 basis points of cuts last year, if the Fed needs to stimulate the real economy, they're going to have to do much more to support. If we couple that with all the tariff uncertainty, not just from a headline perspective of what these firms are having to pay to bring goods into the US and what consumers are having to pay, but the administrative challenges that they face as part of that journey, so once again, we feel in that risk scenario, there's far more to be done by the Fed.
LDP: Duration is effectively, in the simplest way, the sensitivity to interest rate risk.
In your scenario, if we do see four or more rate cuts potentially, if we do see that weakness coming through, for bond investors, what does that mean?
HH: I think the answer to that is a little nuanced. Broadly speaking, our portfolio is positioned with a long duration bias so in a scenario where the Fed does have to cut more and there is a slowdown in growth, that would be beneficial from a rates perspective given that yields would typically move lower in that kind of environment. Obviously, there are other factors at play depending on you know where your position in the curve, so our overweight duration position is predominantly in that five-to-ten-year part of the US curve.
If you were to look a little bit longer out the curve, there's other factors that come into play there. It could be the tax bill that Congress is debating at the moment, how that impacts the physical landscape going forward. Broadly speaking, that would be positive for how we're positioned.
From a relative returns perspective, if we do have that scenario where we have a material slowdown in growth, potentially a recession, the level that we're at in terms of US IG spreads that are around 90 basis points over Treasury, you would likely see a widening event in that.
Where we are positioned rather defensively in credit, we would capture returns. From that perspective, it will be on a relative basis, and that poses opportunities to take advantage of names that have been hit by the market.
LDP: It's very much an environment where you want to be active because during periods of volatility, an active approach can be your friend. In a very benign market, it can be more challenging.
HH: I completely agree with that. If we zoom in on the strategies that I cover in my role as an Investment Director and look at the environments where we've done well, historically it has been in times of heightened volatility.
We construct our portfolio from a defensive starting point with a focus on liquidity, so we only buy a name if we feel that we can get in and out of relatively quickly.
In an active fund in the context of how we're positioned and our philosophy and style, we welcome bond volatility.
LDP: You've painted a picture of some economic weakness, which for a bond investor is counterintuitive, but can be a good thing in terms of the portfolio.
What are some other possible scenarios that you're thinking about that maybe aren't your base case?
HH: I think it's worth mentioning stagflation, right? That's on the tip of everyone's tongue. In a scenario where we see a pickup in inflation, a weakening of growth, that is going to be a challenging environment.
If we look at how the portfolio is positioned at the moment.
In that stagflationary scenario I think it depends on the magnitude of inflation versus the growth picture and the demand for labour going forward. As we know, the Fed has a dual mandate of price stability and maximum employment. So even in that stagflationary scenario where we see inflation above the Fed's core Personal Consumption Expenditures (PCE) target, if the labour market does weaken materially, which we think is indeed a risk, we could still see the Fed cutting more than the market expects, even if inflation is slightly above that 2% target range that we have.
Much has been made and we've challenged this quite a lot. Sometimes the pushback we receive to our contrarian views is let's have a look at the 2024 labour market data; it feels quite robust and the headline numbers look great; unemployment's ticked up, but it's not awful. How we really challenge that we do not believe that the labour market was anywhere near as strong-footed as many do believe?
The reason we believe that is if you look a little bit into the details, 80% of the growth in payroll numbers last year in the US were from two sectors, the healthcare sector and the government sector. Well, we won't go into too much detail, but they're both sectors for many reasons that are facing quite a lot of challenges this year.
If you look at some of the data that's coming out, many Americans are unemployed or struggling to find temporary employment. We think that the labour market is nowhere near as strong as we expected. If you throw in the tariff noise, the uncertainty, how that's going to weigh on businesses going forward, once again, right now we do have that pause, but we don't know what the next headline's going to be and neither do employers. Let's see how that unfolds.
LDP: Looking forward, there's a lot of unknowns. Notably with the tariffs, it seems to be a moving target.
What are some of the key things you're focusing on?
HH: Going forward, we're focussed on the labour market, how that translates into the actual data (not soft data). If you're an American on the ground, your views on how easy it is to get a job or how long it takes to get a job if you're out of work, this may be warning signs. So, we'll really be monitoring the trajectory of the labour market going forward and how that impacts the path of the Fed.
Obviously clearly, inflations on the tip of everyone's tongues, you know, how do companies absorb those costs? Do they pass those onto the consumer? Do they have scope to even pass those on to the consumer? As with the inflation that we had in 2022, 2023, etc., there's been a real trading down element from US households. That shock of 'I'm just not paying anymore'. Can they afford any higher prices? I'm not so sure and we're unsure. So, we're really going to be monitoring that.
Of course, it's the pathway for the Fed, how they flip-flop between their dual mandate, is it going to be inflation or is it going to be the labour market that really pushes their hand? We do believe, like I touched on previously, even if core PCE is slightly above their target, i.e. inflation is running a little bit higher, if the labour market really does start to weaken, we feel that that hand will be pushed on that front. We've touched a little bit on the direction of US investment grade, global corporate in general and spreads. We're at a junction where they are quite tight, where are they going to go from here?
Technicals remain quite strong despite valuations being quite expensive from an all in yield perspective. If you're a buy and hold investor, insurance company, a pension provider, whilst at that spread level, they're not quite attractive, on an all in yield perspective they are. So, we think that's been a backdrop for quite a while, keeping those tight. Can that continue? We're unsure. We think that the slowdown in growth, the uncertainty ahead, that will begin to weigh on them at some point. But within that, there are, once again, opportunities from a bottom-up perspective.
LDP: It feels like bonds are certainly part of the centre stage currently. From a portfolio perspective, they are certainly an important pillar as we see more positive bond yields but also correlations between bonds and equities come down, which, from a broader portfolio perspective, offers diversification.
