Diversity should now be of paramount importance to fixed income investors amid a shift in valuations away from fundamentals, with active allocation the key to avoiding pitfalls in uncertain times, Legg Mason Western Asset has said.
The best way to tackle such an environment is to remain flexible, according to Ian Edmonds, Portfolio Manager at Western Asset, a subsidiary of Legg Mason which manages US$444.5bn of fixed income assets.
Edmonds said the jump in volatility could create opportunities for those investors able to exploit them.
“The current slow growth and low inflation backdrops both here and abroad have not changed, but it is important to us to remain flexible so that we will be able to react to different scenarios,” Edmonds said.
“The bond market has moved too far, too fast, but the evolution of Trump’s economic policies from here will be crucial, and our view is that the jury is still very much out.”
In such an environment, Edmonds said there were a number of areas which looked attractive which the team has been allocating to recently.
These include some parts of the local emerging market debt space. Emerging market debt (EMD) has enjoyed a positive 2016 as investors around the globe have sought out the highest yields available, with US dollar-denominated debt in particular delivering attractive returns.
Local currency debt, whilst also in positive territory year-to-date, has lagged somewhat, and Edmonds said this discrepancy has created a number of attractive opportunities across the region.
“We are favourable on select local EMs,” Edmonds said. “A variety of factors are driving this, including the higher yields, more favourable investor sentiment to the asset class, improved domestic fundamentals and decreased near-term concerns over China.”
The outlook for emerging market debt has shifted significantly throughout 2016, with growth concerns alleviated by upbeat outlooks, not least from The International Monetary Fund’s July (IMF) World Economic Outlook report. The report revised the growth outlook for some major emerging markets – including Brazil and Russia – upwards, adding global growth should expand from 4.1 percent in 2016 to 4.6 percent in 2017.
Edmonds said current currency valuations in EMs were the final factor making some countries stand out against competitors.
“Currencies in emerging markets have stabilised recently and many now look attractive given weakness over recent years and domestic macro policies that are either stable or on an improving trajectory,” he said.
Edmonds said there were also opportunities in bank loans and non-agency mortgage bonds.
“Currently the portfolio has a bias to high-yield and global EM debt. Although we remain positive on high-yield, we have been reducing some exposure recently given the sector’s strong performance this year and are rotating some of that into bank loans given they have a lower volatility than high-yield but still offer attractive income,” the manager said.
The situation remains very fluid across fixed income markets however, making it hard for investors to make long-term allocation decisions. Ken Leech, Western Asset’s Chief Investment Officer, explained: “The initiatives Trump has outlined for his first 100 days constitute a clear break with the pro-globalization policies of the past 30 years, but it is far from clear to us how this will play out.
“There are strong potential risks, and the optimistic scenario being priced into today’s markets may be overdone.”