James Gard: We’re here at the Morningstar Investment Conference. I’m delighted to have with me Ariel Bezalel. He is a fixed income fund manager for Jupiter. Welcome.
So, with great timing, the Fed is about to announce its interest rate decision tonight. You’re slightly more dovish than some in the market in terms of where you expect the Fed to be positioned this year. Can you just give us an idea of how that affects your positioning and what scenarios in terms of returns you’d expect?
Ariel Bezalel: Yeah, absolutely. So, back end of last year, we had, what we called, the Powell Pivot. We had quite a dovish pivot by Jerome Powell. We’ve come into this year, and at one point, we’re expecting something like six to seven rate cuts. And due to the strength of economic data combined with sticky inflation pressures, the Federal Reserve has really backtracked and guided markets to expecting rates to remain higher for longer. So, now we’ve got only one rate cut priced in and that’s not until December of this year.
I beg to differ. I think near term, the Fed are a bit rabbit in the headlights. They’re very confused about what’s going on. But I believe that monetary policy is acting as a drag on real economic growth. We are seeing quite a divergence, for example, between the soft data and the hard data. The soft data is telling you that the economy is slowing down. The hard data is still painting a fairly robust picture of the economy. But nevertheless, we are seeing a lot of little cracks within the economy. For example, deterioration in commercial real estate. We’re seeing things like restaurant sales tailing off, hotel sales – occupancy rates tailing off. We’re also seeing a lot of leading indicators telling us that the labour market has seen its best days and a US consumer that’s now looking really stretched. And the US consumer is 70% of GDP. So, I think over the course of this year, we’re likely to see the slowdown unfold probably in America. I think that will probably lead to the Fed having to revisit the more hawkish policy that they’ve adopted lately.
Gard: Sure. So, that opens the door for rate cuts, and more than the market is expecting. Moving closer to home, you think UK gilts are attractive for the similar reasons in that inflation is fairly done in the UK and Bank of England is in a better position than the market might think in terms of rate cuts?
Bezalel: Yes, same picture really. We’re seeing the UK economy really stagnating now. We’re beginning to see the labour market really start to normalise. Job vacancies have been rolling over. On top of that, retail sales have been pretty sluggish. We had in the last few days, we’ve seen the British Retail Consortium talking about goods deflation, which is really interesting. I think in the coming months, we’re going to see inflation in the UK really come off and actually pave the way for around the middle of this year for the Bank of England to begin that rate cutting cycle. What I would also throw into the mix is what we’re seeing globally is money supply growth has already ground to a halt. We think that kind of mountain of excess liquidity that was built up over the last two to three years is really now evaporating and that should help to bring inflation down as well.
Gard: Sure. You talked about the global economy being chronically indebted. That’s maybe not great for consumers or governments, but maybe makes it easier for bond managers or…?
Bezalel: Yeah. I mean, the way we think about debt is, firstly, you’ve got to think about all those cash flows that are being diverted from doing productive things, so basically simply paying interest with it. On top of that, you’re seeing governments in Europe, in America, taking a bigger, bigger share of GDP. That’s bad for economic growth. Governments do not know how to allocate capital efficiently. Therefore, that has a bit of a – it acts like a heavy weight on economic growth longer term. Debt in general is very pernicious for economic growth. All this debt, we’re building up at the government level, at the private sector level inevitably means lower and lower economic activity going forward. It’s very deflationary.
Gard: Sure. Yeah. But that helps with the lowering interest rate argument.
Bezalel: Spot on. Inevitably, we think this heavy debt load acts as a heavy hand on economic growth, helps to slow down inflation eventually and then paves the way for central banks to start cutting rates.
Gard: Sure. That’s good news for homeowners, I guess. Moving on to corporate bonds, high-yields you were saying in your presentation that you have one of the lowest exposes to high-yield corporate bonds you have for a while, but you still like the corporate bond investment-grade sector.
Bezalel: Yeah. So, if you look at Europe, for example, if you Excel 10% of the widest trading credits, so you’re looking at the core part of the high yield market in Europe is basically trading one of the types at about 300 over. The overall market today in Europe trades at around about 400 over. You go back to 2000, average spreads have been around about 600 over. So, we’re trading well through the averages, and so we’re not really getting much in the way of a compensation for a slowdown and perhaps a recession in the European and the US economy. So, high yield, I think one should treat with caution.
Returns year-to-date in high yield have actually been in line with cash, fairly lacklustre. Investment-grade returns are year-to-date around about 0.5%. So again, it’s been a bit disappointing for a lot of investors who’ve been piling into investment-grade. And so, with the lack of compensation we’re getting, we think we should be looking at credit as a source of carry. So therefore, we’ve been diverting a lot of our exposure to credit to much more defensive sectors, short-dated paper, a bias towards senior secured paper. And so, we’re looking at as a source of carry to the portfolio rather than a place where we’re going to generate big capital gains.
Gard: So, it’s kind of you are worried about default risk and I think with a slowing in economy and indebted consumer default risk seems like a logical…
Bezalel: There’s absolutely that factor. And the other thing you’ve got to bear in mind is, is that a lot of companies now that are refinancing debts are having to refinance at a much, much higher interest rate. So, you’re seeing a lot of those old coupons going from the high yield space, 4%, 5%, 6% to double-digits-plus in a lot of cases. And that’s sucking out a lot of cash flow and inevitably puts a lot of companies on the brink.
Gard: Yeah. That makes sense. So just as a final question, you mentioned this has been the kind of hardest period in your career to manage money. Can you elaborate on that?
Bezalel: Yeah, absolutely. I think really the response to that is, is because we have so much economic and geopolitical uncertainty. We saw this massive fiscal response, this huge inflationary surge over ’21 and ’22. And central banks wanting to put inflation back in the genie. And that’s created a lot of volatility in bond markets. But also, on top of that, it’s really hard to judge when – we found it very difficult to know versus previous economic cycles when the turn is happening, it’s really difficult to call because of that kind of excess liquidity we have in the system.
The other thing I would highlight, I think what we’ve been surprised about has been the resilience of the US consumer. The US consumer over the last two, three years has been parting like it’s 1999. They’ve been flush with all these stimulus checks. And historically, whenever they did get these stimulus checks, they would spend half and save half. This time round, they’ve gone out and spent a lot. And that’s been a hard thing to call is when that consumer spending tails off.
Gard: Sure. But you think that we’re at a pivot point.
Bezalel: But I think we’re now at a pivot point. Looking at all the numbers we’re seeing, we’re seeing credit card delinquencies are on the rise. We’re seeing auto loan delinquencies are on the rise. Commercial real estate loan souring. So, a lot of telltale signs now that consumers and businesses are beginning to get a bit tapped down. We also saw a piece the other day showing that a bit over 40% of smaller businesses are struggling to pay their rents. So that’s huge. So, a lot of these kind of anecdotal stuff we’re paying attention to because inevitably it melts into something quite big.
Gard: Yeah. Anyway, it’s going to be an interesting year for lots of reasons. But thanks very much for your insights, Ariel.
Bezalel: Yeah, it’s been a pleasure. Thank you.
Gard: Yeah. Thank you.
