Talking Heads – The case for sovereign debt in multi-asset portfolios – and for gold

This is an audio transcript of the Talking Heads podcast episode – The case for sovereign debt in multi-asset portfolios – and for gold

Daniel Morris: Hello and welcome to the BNP Paribas Asset Management Talking Heads Podcast. Every week, Talking Heads, we’ll bring you in-depth insights and analysis on the topics that really matter to investors. I’m Daniel Morris, Chief Market Strategist, and I’m joined today by Mark Richards, Head of Flexible and Absolute Return and our multi-asset team. Welcome, Mark, and thanks for joining me.

Mark Richards: Hi, Daniel. Thanks for having me.

DM: Recently we’ve had more change, more unexpected news in the markets than normal. I highlight two things. We did just have a meeting by the US Federal Reserve, so that’s always important for the markets as they assess what the Fed thinks and what the Fed said or didn’t say. Probably most interesting, we had a surprisingly soft inflation print out of the US. So, one of the lessons is that we’re still quite surprised by the data, seemingly on an almost continuous basis, and I would imagine that makes your job somewhat more interesting. Let’s start with the Fed then. If we think all the way back to the end of the last year, the markets thought six or seven [rate] cuts were coming from the Fed. But now they’re only looking for one more cut this year. That’s in line with what the market’s expecting. Are we in the right ballpark now or where do you think we might end up?

MR: You’re certainly correct to touch on data volatility and arguably central banks who have always tried to have an anchor around what is a neutral level of interest rates, how accommodative or restrictive monetary policy is at any one point in time. They’re struggling with how firm that anchor is. Why don’t you have to go back even further to pre-COVID when it felt like in 2019 or even 2018, a lot of the central banks had given up forecasting inflation. If you cast your mind back to [Jerome] Powell, chair of the Federal Reserve, it all came out fumbling around in the dark to find where the neutral level of interest rate is now. They’re also fumbling around in the dark, but there is a slight dovish bias. They’ve clearly had two- and a-bit years of inflation being well above target.

There’s certainly been some worrisome data at the start of the year in terms of inflation. And although they say that they want to see a little bit more evidence, one has to look at how they talk about the data and what they’re referencing and if that reveals a slight dovish bias. So, not the meeting just gone, but the one before. Of all the inflation and wage data that Powell could have referred to, he referred to the Indeed wage tracker, which is one of the indicators that slowed most pronouncedly and is showing that labour market inflation is under some control. In terms of the components of inflation and the numbers out very recently, it’s worth looking at some of the components because shelter is typically a fairly sticky component. We have a fair amount of alternative data on rents that show a degree of slowdown, but that’s not really coming through.

While there’s been a dip in the right direction, it’s not plain sailing to say that inflation is going to come quickly back to target, but I do think there is a slight dovish bias in the Fed, and that’s because when we look at the activity data, it’s quite mixed. The Fed’s dual mandate is always going to be biased towards the labour market and the health of the economy rather than inflation. For much of the period of central bank independence, this has been an easy trade off, with inflation being well under control. The last two or three years has been more difficult with inflation being well above target.

But crucially, growth has been okay. As there’s tentative signs of growth slowing, they will refer more towards the labour market. In terms of the recent dot plot that came out showing just one cut for 2024, it was also accompanied by a forecast of the unemployment rate. We’re at 4% and it’s very unusual for the unemployment rate to reverse course. So, there is going to be more of a deterioration in the labour market that allows the Fed to be more dovish than market pricing despite inflation not yet being back at target.

DM: All of this is having a noticeable impact on bond yields. What’s your view? And when you think about the fixed income market more broadly, where do you have the highest conviction?

MR: For the last few decades, the role of duration in multi-asset portfolios has been pretty clear in terms of being negatively correlated with risk assets and inflation not really being on one’s horizon. Now it’s quite a different setup. So even though we can look at a potentially more dovish central bank community and potentially extrapolate that into longer-term bond yields and an attractive view on duration, there are a couple of important barriers. One is definitely on the fiscal side: governments running deficits of 6-7 percentage points of GDP in an environment where growth is strong is very unusual. It doesn’t feel like the political climate will allow for governments to revert back to the austerity that characterised the post GFC environment, the great financial crisis.

After the great financial crisis, it was really central banks and loose monetary policy. That was the key tool. But you also remember that fiscal policy was really concerned about tightening budget deficits, almost getting surpluses and restraining government debt to GDP. Post-Covid, we live in an era of loose fiscal policy and attempts to tighten monetary policy. There is a material risk of the bond market imposing some degree of discipline on governments. So, the role that duration plays in multi-asset portfolios is definitely under review and that leads us into looking for other areas of diversification, defensiveness in portfolios.

If there is a material recession on the horizon, duration’s role will certainly come to the aid of multi-asset investors. But if it’s more of a modest slowdown and a very expansive fiscal policy, which seems to be still the case over the next one to two years, we have to look elsewhere and look away from duration, specifically in terms of fixed income. We still have a degree of positioning in investment-grade, most notably in European investment-grade credits. Spreads have certainly tightened, but we think in a relatively sanguine macro environment, that’s still a pretty attractive place to be in the sovereign space. We are short Japanese government bonds. We really think there is a secular change in the inflation dynamics in Japan and a secular change in monetary policy. Having been at zero for a long time and having a had outright deflation for a long time, the structural forces are in play for the Bank of Japan to move off of that zero bound and for inflation to be positive. And therefore, Japanese bond yields should be rising.

DM: An asset that perhaps has had surprisingly good returns this year compared to what most people forecast at the beginning of the year is gold. What is your thinking behind that move? And crucially, how sustainable is it?

MR: It’s certainly been a positive contributor to our multi-asset portfolios. There’s a famous phrase from the founder of JPMorgan: Gold is money, everything else is credit. And that serves us well in terms of thinking about safe assets. We saw probably a year or so ago that relationship between the price of gold and the level of real interest rates start to break.

One reason has been the weaponisation of reserves. We live in a more unstable geopolitical environment, and the confiscation of treasuries from potentially bad actors on the sovereign side has seen the risk of premium transferred to things like gold and other precious metals. In terms of whether this can continue, as we move past the US election and are still confronted with large fiscal deficits and questions about debt sustainability, the allocations to actual money and stores of value will continue to rise.

DM: If I could summarise some of the key points that you made, Mark. You started out by saying you see a dovish bias from the US Federal Reserve and if you think about their dual mandate growth versus inflation, that they’re probably going to be biased towards keeping growth up as opposed to getting inflation down quickly. We think about the implications of that for government bonds and duration and in particular the role that they play in a portfolio. On one hand, an outlook for inflation eventually getting back to target, but then worries about fiscal sustainability and maybe the need for higher yields. And then your comments on the outlook for gold and to the degree that may be replacing or providing that security, that risk-off asset in a multi-asset portfolio. Well. Mark, thank you very much for joining me.

MR: Thank you, Daniel.