Stay in quality credit as crises come to a head

Standish argues investment-grade credit is a much better place to be than high-yield bonds.
Stay in quality credit as crises come to a head

Standish, the fixed-income arm of BNY Mellon Asset Management, says it has gradually added risk since the summer in the form of investment-grade bonds.

“We’re avoiding high yield because of market volatility,” says Tom Higgins, global macro strategist at Standish in Boston. “At least with investment grade, you don’t have a concern with defaults, and you do get compensated.”

He notes that since the market swings in August and September, aggregate spreads for US investment grade against Treasuries of like duration widened from 150-175 basis points to 200-250bp, suggesting opportunities for capital gains when market confidence returns.

Moreover, US companies are sitting on huge piles of cash (about $2 trillion in total, says Higgins), evidence that their balance sheets are strong.

The question, of course, is when and how that cash gets utilised: does it get returned to shareholders? Does it get invested into IT, into capex, into new hires? For fund managers, no answer is likely for a while, as long as the macro picture is so unclear and Western households continue to deleverage.

Higgins made these remarks to AsianInvestor while visiting Asia with his colleague Edward Ladd, chairman emeritus who is a few months away from his 50th year of service at the firm.

That accumulated wisdom has proven difficult to harness in this environment, however. “This crisis rattles the foundations,” Ladd says, noting that throughout his career, 10-year US Treasury yields ranged predictably around 3-4%. Today they’re 2% and have flirted with even lower levels.

“An important skill for a fund manager is pattern recognition,” he adds. “But sometimes the pattern gets broken.”

He praises the US Federal Reserve Bank for being bold and “entrepreneurial” in the face of the global financial crisis, but each unorthodox measure is proving less impactful. Although there is now serious talk of a ‘QE3’, it may prove unlikely to achieve much, particularly as long as the government is bent on retrenching fiscally.

Ladd and Higgins point to two themes underpinning the current crisis. For Ladd it’s the unprecedented scale of US unfunded liabilities.

For Higgins, it’s about how the US has been able to behave in such a spend-thrift manner. His conclusion is that the sheer dominance of the US dollar as the global reserve currency hasn’t done America any favours; if anything, it has proven a curse, and efforts to have the euro and renminbi evolve into currencies also capable of reserve status are going to be critical to returning the US economy to health.

Roughly speaking, America has amassed the following unfunded liabilities (above its current budget and household deficits): $35 trillion in Medicare (healthcare spending for the elderly); $15-20 trillion in Medicaid (healthcare spending for the poor); another $15-20 trillion for Social Security (although this can be solved with relative ease); and $4 trillion in state and municipal debts – a figure that is likely to rise as more public pension funds become more realistic about their long-term investment returns.

The healthcare bill has been exacerbated by a deal between former President George W Bush and Congress in 2004 to extend healthcare coverage to prescription drugs, which is adding a further $8 trillion in expected liabilities.

“The lesson is that national balance sheets matter,” says Ladd, noting that bond investors during the Great Moderation years of 1980 to 2007 failed to take these seriously enough when they did their analysis.

The primacy of the dollar, and its status as a liquidity haven for central banks and other investors, has kept interest rates so low for the US that it has racked up these debts with ease. Fortunately the dollar’s role, although likely to remain central, is going to decline in relative terms.

Already it has declined as a share of global central bank reserves from around 70% in 2000 to about 60% today, partly due to depreciation but also because central banks are actively diversifying.

The biggest gainer has been emerging-market currencies, which have seen their collective share of global reserves rise from 2% to about 5%, says Higgins, citing IMF data. (Sterling and yen each stand around 4% and the euro’s at 27%.)

The rest of the world has benefited from the dollar’s reserve status, because it helped to foster trade. Asia has been a huge beneficiary from this system. Even in the Atlantic world before World War I, often regarded as a golden age of globalisation, sterling didn’t enjoy such primacy; it shared the stage with the deutsche mark and the franc.

Back then, the reserve currency made transactions easier in a world without computers; today, the reserve status is more about liquidity. But, just as the US used its surplus of gold reserves in the wake of World War I to assert the dollar’s primacy over sterling, Asia, led by China, is doing something similar today.

The message, however, is that this will benefit the US, because the outsized role of the dollar has come to outweigh the benefits of reserve status. Higgins says the US should welcome a gradual expansion of the role for the renminbi and the euro (assuming it survives, in some form).

For fund managers, the greatest opportunity over this coming era is to be found in the expansion of emerging-market capital and currency markets.

Global reserves have already begun to flow to emerging-market debt. Western pension funds, insurance companies and other institutional investors will follow. Home bias and market volatility is keeping them at bay, for now, but Higgins says things can change fast.

There’s a lot of money invested in short-term US Treasuries that will be looking for a new home, once investors feel they can start to look more toward the longer-term horizon.

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