7 min read 23 Nov 21
Richard Woolnough, fund manager of the M&G (Lux) Optimal Income Fund, assesses the state of the economy and markets as we approach the end of 2021 - a slightly more settled year in terms of market volatility, but still challenging for fixed income investors as fears of inflation dominate the outlook.
Q: Richard, what is your assessment of the global economy?
The global economy has started to recover strongly from the damaging effects of COVID-19. Governments and central banks took decisive and necessary action in the form of proactive fiscal policy and maintaining interest rates at very low, even zero and below levels, to support spending and confidence. Of course, a consequence of an economy that is rebounding with such force is rising inflation, in the form of higher commodity prices, more spending on consumer goods, and rising wages.
One area of the economy that is under scrutiny, as growth picks up and interest rates remain accommodative, are labour markets. We are close to full employment in a number of economies and the so-called ‘quit rate’ – people voluntarily leaving their job – was at an all-time high as recently as September. We believe a very vibrant labour market will potentially result in higher wages and more sustained inflation going forward.
Q: Given this reinflationary environment, and that inflation can typically be a drag on bond markets, how is the fund positioned?
Firstly, let us consider the roles of duration and credit. Despite rising inflation, central banks remain ultra-accommodative, with interest rates close to zero. In this environment, as long as central banks lag inflation, we believe credit markets should remain well supported, because default rates will likely remain low. We have been shifting away from US dollar investment grade corporate bonds mainly into European corporates as we find the latter more attractive. In particular, we are focused on banks – they offer a wide range of opportunities, in our view, from highly-rated paper to high yielding subordinated bonds. Also, banks are tied to the economy, so tend to do well when economies improve.
From a duration perspective, we believe that the combination of monetary and fiscal stimulus could result in higher growth and higher inflation. This in turn will put pressure on government bonds. Moreover, government bonds don’t offer a favourable risk/reward as rates are generally close to zero, therefore offering limited upside in their price. In this context, we maintain a low duration positioning in our fund compared to the wider market.
There are some other tools we can use within the flexible approach of our fund, which give us the freedom to move between different fixed income asset classes (investment grade, government bonds and high yield), and even into equities (a maximum of 20% of total assets). We have favoured equities issued by companies operating in cyclical sectors, which traditionally benefit from an improving economy. This includes consumer discretionary, energy and healthcare sectors.
We have also been active in inflation markets - buying or selling government bonds indexed to the inflation rate (index-linked bonds) as we try to gauge the path of inflation in the coming period. For example, last year we added long-dated US TIPS (Treasury Inflation-Protected Securities) as they were pricing in a very low inflationary environment. This was inconsistent with our view. This year, we have focused more on Japanese and eurozone linkers. We reduced exposure to the latter just recently as inflation in the eurozone has surprised to the upside and inflation expectations have risen significantly. We have also introduced an underweight position in UK inflation using derivatives.
Q: From October 29, the fund became an ‘Article 8’ classified fund under the new Sustainable Finance Disclosure Regulation (SFDR) introduced by the European Commission. Can you explain what this means in terms of fund portfolio changes?
An important change this year has been the classification of the fund to an ‘Article 8’ fund under new EU regulation. From October 29, we follow a positive ESG tilt approach, aiming to deliver investors a weighted average ESG score above that of its benchmark. The fund will also broaden its norm-based ESG exclusions, e.g. companies in breach of the United Nations Global Compact (UNGC) principles, and the government bonds issued by countries assessed as “not free” by the Freedom House index.
Q: In the context of inflationary pressures, what is your view on the economy for 2022?
We continue to maintain a positive outlook for economic growth for the rest of the 2021 and into 2022. But a consequence of this is inflation – as discussed above - and we believe it will end up being higher than what we have been used to in previous inflation cycles, and also more permanent. We are therefore wary of holding too much duration and cautious on getting caught up in overvalued corporate bond markets, although we continue to look for attractive opportunities, particularly in Europe and UK markets and in sectors such as financials.
The main risks that could affect performance of the fund
The fund allows for the extensive use of derivatives.
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