“We are much more constructive on fixed income, in particular on the government bonds which are offering the safest return,” Christophe Machu, head of the European multi-asset portfolio management at M&G, told Delano last week. “We were much more negative starting from late 2021 as we have noticed a large dichotomy between rates at negative levels of close zero whereas inflation was gradually increasing.”
Machu explained that M&G has normalised its developed market bond exposure given the attractive and positive real return on the back end of the yield curve. He estimates the level at 0.5% to 0.8% on the German bund market and 1.5% in the US. The real return reflects the difference between nominal yield and expected inflation which they calculate by blending the 5-year forward inflation expectation rate and an average of economist expectations on inflation.
Emerging market currencies have held up despite the strength of the dollar
At current nominal rates, “we would need a significant shift in long term inflation to annihilate the current real returns,” said Machu. “Secondly, a bond exposure offers a source of diversification should growth decline.” M&G complements its exposure with very short T-bills exposure, which carry a yield of around 5.5% in the US.
Emerging debt markets: stable and adding diversification
“Emerging markets are also subject to the development of the inflation and economic growth, but they also add diversification,” commented Machu. He observed that the nominal yield and the real return are significantly higher than for the developed markets whereas there is a “gradual move of inflation, in the last 20 years, toward the levels seen in the western world.”
Interestingly, the emerging markets have not suffered, overall, from the typical vicious circle of foreign investor outflows resulting in currency devaluation and then an increase of inflation during the covid pandemic. There has been rather some sort of stabilisation “with Brazil, for instance, deciding to increase rate in advance to avoid major investors outflows,” observed Machu.
A preference for local currency debt in the emerging market
“Emerging market currencies have held up despite the strength of the dollar,” said Machu. He commented that their investment in local currency debts enjoyed the benefits of higher yield return and appreciating local currency coupled with better economic growth than expected by the market.
“A potential weakness of the dollar should boost emerging market currencies in addition to the high nominal yield.” With a carry rate that Machu estimates at 10% for their most diversified portfolios, he sees ample buffers against an appreciation of the dollar.
“Given the composition of the emerging market benchmarks, the focus of bond investors is on South America, with some exceptions, whereas it is Asia for equity investors,” noted Machu. M&G prefers bonds from Mexico, Colombia, Brazil and South Africa, with the latter offering yields as high as 12%. “We tend to be diversified and we prefer relatively liquid bonds,” added Machu. Argentinian bonds are seen as too volatile with low liquidity, whereas India offers low yields on its bonds and low return potential on the equity.
Stock markets: better opportunities outside of the US
On the stock markets, M&G is “relatively positive on markets outside of the US” and they are staying out, overall, of the US markets as they have been historically more expensive only twice in the last 25 years--after the technology bubble in [the early] 2000s and after covid in 2020-21”. In addition, Machu noted that earning expectations have been revised downward for US companies in 2023 and 2024, whereas the opposite is true for the European, Japanese and emerging markets.
“A controversial view amongst many investors, we have increased our exposure to Chinese equity starting in the middle of 2022 when the country was still under lockdown […] mainly through ETF and futures,” said Machu. M&G likes the Chinese markets given that it is uncorrelated with the other markets as observed with the strong gain and decline in the first half of this year.
This article was published for the Delano Finance newsletter, the weekly source for financial news in Luxembourg. .