In this Q&A, Richard Woolnough, who manages the Optimal Income strategies, and Charles de Quinsonas, who manages emerging-market debt, answer questions about key current issues in fixed-income markets. Their answers highlight the dynamic nature of the global economy and financial markets and the need to take a flexible approach that can maximise the potential for income generation.

Question: It’s generally agreed that there is an 18-month time lag between a change in monetary policy and its impact on the economy. Given that the Federal Reserve first started raising interest rates in March 2022, should we be seeing more signs of an economic slowdown?

Richard: The Federal Reserve has been gradually raising rates since March 2022 and began from a point when monetary policy was exceptionally stimulative, so it will take time for the effects to be felt. We’ll see the impact on inflation over the next year, and we might also observe stresses in property and other sectors.

Question: Inflation is less of a problem in the emerging world than in the developed economies. Is that supportive of emerging markets?

Charles: Asia certainly hasn’t experienced the same inflation problem as the developed world, but that isn’t the case in Latin America, Eastern Europe or Africa. The proactive approach taken by central banks in emerging economies in hiking interest rates early is what really differentiates these economies from their developed counterparts. Sharply falling inflation resulted in elevated real yields among local-currency bonds, which supported performance this year.

Question: Has the rise in the value of the dollar prompted you to reassess your view of the outlook for emerging-market currencies?

Charles: We don’t buy local currency based on a view of where the dollar is heading. We buy a basket of currencies based on those currencies’ particular merits. If we think that the dollar will get stronger in the next 12 months, that might have a marginal impact on our local-currency exposure. Currently, though, we can find many opportunities in emerging-market local currencies. We’ve been taking profits from Latin America and rotating into some of the Eastern European countries that are benefiting from falling inflation – and also into Asian currencies, such as the Malaysian Ringgit, that offer good value.

Question: Do you think the global economy will experience a soft or hard economic landing?

Richard: Both are possible. If inflation starts to fall and central banks don’t prolong the higher-for-longer interest-rate policy, then we’ll see a soft landing or even no landing, ie economies will continue to grow.

If, however, central banks keep rates too high for too long because of concerns about inflation, a hard landing is far more likely – and that could be problematic for markets. Indeed, even a soft landing could cause some difficulties in areas of the market such as corporate bonds.

Charles: My view is that the tighter monetary policy is starting to affect the real economy in many parts of the world. Refinancing risk is building up, and I believe that will contribute to whether a soft or hard landing occurs. Whilst we’ve been reducing corporate exposure in the single-B area across our emerging-market debt portfolios, we continue to hold a long position in US dollar, high-yield emerging-market sovereign bonds. That’s because we can still see value in the latter area, while that isn’t the case among emerging-market corporates.

Question: Higher interest rates will have an impact on the level of defaults. With that in mind what’s your view about the very high yields now seen in some frontier government bonds?

Charles: We regard these very high yields as an opportunity, provided careful analysis of the issuers is undertaken. Some issuers have been unfairly punished by the market – indeed, the current situation is a good example of how active management is so important in emerging markets. History also suggests that there is significant potential to benefit from the carry trade – borrowing in one currency at a low interest rate and investing in a currency that has a higher interest rate. We can’t be certain that the carry trade will prove profitable going forward, but the opportunity is certainly there.

Question: Richard, are you concerned about the large number of companies in the high-yield sector that will need to finance their debt at much higher borrowing costs?

Richard: Fortunately, most businesses refinanced their debt when borrowing costs were low, and they’ve adopted realistic plans to reduce debt levels. In addition, and this isn’t widely known, public markets have been very selective about who they lend to. Consequently, the general quality of high yield is markedly higher than previously. In addition, companies in the advanced economies can now use the service of a group of funds and legal teams that can provide specialist funding to the bond market. As a result, the probability of default is relatively lower than in the past.

Question: Richard, if you don’t anticipate a recession, why are you overweight in duration at the moment?

Richard: It’s simply a question of valuation. We believe inflation is headed back to target in the US, which will result in real yields of 3%. The market is roughly back to where we were in 2007 in terms of bond yields and spread. Thus, the positions I took in 2007 are the ones I should be taking today.

Question: What are the risks and opportunities that lie ahead?

Charles: Given the potential for unexpected geopolitical developments across the world, we constantly ask whether valuations reflect the risk outlook for a particular issuer. However, emerging markets provide a vast opportunity set and high levels of diversification, and they’re enjoying healthy levels of economic growth – particularly in relation to the developed world.

Richard: As bond investors, our duty is to consider which is the optimal duration position. So, we are focused on the outlook for inflation. Will it prove sticky or fall very sharply? I don’t know, but I’m going to try and take a view of where inflation is heading based on all the evidence I can gather. Looking forward, there are, as ever, challenges. There is much talk about the death of globalisation, productivity growth and technological change, and all the geopolitical difficulties now facing the world. However, I find it hard to believe the world we’ve known for the past 20 years has simply disappeared. I think it’s still in the interest of people and governments across the world to cooperate. So, I’m optimistic that the outlook for many asset classes is positive. Globalisation and technological progress are continuing, and that should help to control inflation and support growth.

Flexibility is key

In summary, the outlook for the global economy remains highly uncertain. Much will depend on the outlook for growth, inflation and interest rates. The resilience of the global economy and inflation has continually confounded analysts’ predictions in 2023 and further surprises could well take place. This backdrop underlines the importance of adopting a flexible approach when it comes to income generation. The ability to invest across the spectrum of income assets and to adjust allocation among the various sectors to maximise potential income is paramount. 

The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. The views expressed in this document should not be taken as a recommendation, advice or forecast. Past performance is not a guide to future performance. We are unable to give financial advice. If you are unsure about the suitability of your investment, speak to your financial adviser.

The content of this page reflects M&G’s present opinions reflecting current market conditions. They are subject to change without notice and involve a number of assumptions which may not prove valid. All information included in this page has been written for informational and educational purposes only and does not constitute an offer or solicitation to invest into any security, strategy or investment product. Information given in this document has been obtained from, or based upon, sources believed by us to be reliable and accurate although M&G does not accept liability for the accuracy of the contents.