Can you give us an overview of the strategy that you adopt for the St. James’s Place portfolios?
For the funds that we run on your behalf, we look at the high yield corporate debt universe, with an occasional investment in the sovereign world [debt issued by governments]. At BlueBay, we look very much at bottom-up fundamentals, that is the specific characteristics of individual bonds. That is quite typical for the corporate bond asset class, but when looking at emerging market bonds, we believe it is also important to look at top-down themes too.
For example, at the moment, our asset class is being influenced by a number of external factors. So, monitoring the outlook for monetary policy by watching what’s happening at the US Federal Reserve (Fed) and the European Central Bank (ECB), is very important. Plus, we must maintain an eye on what is happening in China and on general economic growth rates around the world, because these are all relevant to what will happen within our markets.
So, although we are very much a fundamental investment house, we must incorporate this macroeconomic overlay into our thinking. But in essence, you can think of the portfolios as a mixture of what we view as the best-in-class high yield credits from within emerging markets.
What is your view on the outlook for inflation?
That is the million-dollar question at the moment. We have certainly seen some outsized inflation datapoints recently, most importantly in the US. We are also seeing some inflation in emerging markets, stemming primarily from the cost of commodities such as oil and some metals. These are important commodity markets for us to be watching. There is a flipside, of course, because some emerging markets are big exporters of these commodities, so their current accounts can actually improve as they start to export at higher prices. So, higher inflation can be a double-edged sword in emerging markets, depending on how it originates.
The key question really is how central banks will look at this inflation. Can they paint it as purely being transitory? Or will it be viewed as something more enduring? The most important central bank is, of course, the Fed. And the recent rhetoric coming from the Fed suggests that it will be relatively tolerant of inflation. The most recent inflation numbers have caught the attention of Fed officials and they have suggested they will be willing to move interest rates higher to stem inflation if it gets out of control. In a way, that simply brings the Fed into line with market expectations.
Some emerging markets are already beginning to deal with higher levels of inflation. Brazil, for example, increased interest rates by 0.75% in June, in its third rate hike so far this year. So, we’ve moved from some very “dovish” central bank behaviour last year, when we saw large interest rate cuts, to a situation now where most central banks are more “hawkish”, in looking to hike interest rates.
Wouldn’t higher interest rates in emerging markets be bad news for their bonds?
Well, that depends on what’s already priced in. Bond markets have a habit of adjusting prices in advance of expected policy action. So, investors have been watching the inflation trajectory and anticipating a combination of some inflation coming through and continued fiscal expansion in many economies. As a result, yields have already moved significantly higher.
For example, in the first quarter of this year, bond yields [the returns that investors receive on their investments] in some emerging markets were moving on a two-for-one basis, compared to what US Treasuries experienced. The yield on US Treasuries increased by 80 basis points (0.8%), whereas for some emerging markets, yields increased by 150 to 160 basis points (1.5-1.6%). So, there is a fair bit already in the price.
Which sectors and regions do you think look particularly attractive as economies reopen?
An obvious sector that is benefiting as economies reopen is the airlines. Having done well last year by not owning many of the airlines, we’ve been debating the merits of that trade quite a bit recently. We would also point to some of the other cyclical sectors such as oil and gas and mining.
In terms of regions, emerging markets have generally not participated fully in the reopening trade because of the slower pace of the vaccine rollout. Latin America has seen some benefit but here there has been a shift to the left in terms of politics, particularly in the Andean countries, which changes the dynamic of the investment landscape somewhat. So, it is a mixed picture.
More broadly, we remain focused on the fact that there are many different sectors and credits that are exposed to the recovery trade. We are simply trying to pick the best-in-class of these growth sensitive credits.
How do you integrate ESG considerations into your portfolio?
Emerging markets investors have always been strong on the social and governance elements of ESG – these are really at the core of what we do. More recently, we have been working hard to also incorporate the environmental side too. At BlueBay, we have an ESG team that is integrated within the investment team, and it has a lot of input into the scores that we attribute to any security that is considered for the portfolios. So, there is a lot of collaboration between the portfolio manager, credit analyst and ESG analyst in determining the appropriate rating for each credit.
One thing we are careful about is not being too stringent about ESG considerations in isolation. If we were to be too strict on ESG, we could end up penalising some of the very poorest countries. That would be a perverse outcome, because these are the countries that need capital the most. So, we are working hard on the engagement aspect as well, because the more you can engage with issuers, the more you can encourage better ESG practice.
Some credits are, of course, excluded on the back of ESG concerns. But equally, we can enhance outcomes from the portfolio as a whole by targeting credits where we are seeing a material improvement on ESG performance.
Would you ever consider excluding an entire country over ESG concerns?
Yes, there are times when there is simply too much risk. It would come down to a decision on the sovereign. If there was a situation in which the sovereign represented too much risk, we may feel unable to invest in that particular country. It can be very problematic investing in the corporates of that country, no matter how good the corporates are, because, for it to be able to repay you, it is reliant to an extent on the sovereign and on the political backdrop.
That is most likely to be political risk, but there are certainly situations where the overall ESG level of the sovereign is tainted to such a degree that we are unable to invest in some of its corporates. There are many, many credits which we think are fundamentally quite strong, but which we avoid because of a tainted ESG score at the sovereign level.
What are the key risks to your portfolio?
Given our current positioning, one risk would be that we have a faltering in the reopening trade, with global growth rates significantly underwhelming. That is probably a risk that many investors are running right now, because logic would tell you that we are likely to see a continuation of the reopening. Vaccines are proving relatively successful, and we will be looking for emerging markets to be able to accelerate their vaccine rollouts in the second half of the year. This should be quite constructive for growth rates in many parts of the world. But if growth were to falter, that would be a concern.
Elsewhere, if inflation were to pick up much more significantly, forcing the Fed’s hand on interest rates, that could be problematic for the portfolio. Meanwhile, another thing we will be watching very closely is China. There is already a sense that China will not be the growth engine that it once was for the rest of the world, but we will keep a close eye on its debt situation as it continues its deleveraging drive.
So, there’s certainly many risks on the horizon. In the second half of 2021, performance is likely to be influenced by the pickup in growth and the gradual withdrawal of stimulus, particularly by the Fed. These are competing forces and emerging market credit will be in the middle of it. But we feel comfortable in our positioning and confident that we can monitor the fundamentals and the evolving default outlook. Ultimately, these are the key anchors for us.
Why are you positive on emerging market debt going forward?
Emerging market debt is fascinating from the perspective of its diversity. We have an extraordinary range of investment opportunities – different regions, different sectors, different durations – so we are not constrained to investing across one economic cycle. Yes, the asset class is buffeted by the many external factors that I’ve discussed. But ultimately, we do have a very broad range of investments that we can look at.
It is also positive to be investing in an asset class where growth levels are likely to be improving in the second half of the year, while default levels remain pretty well anchored. So, I think it is a great place to be, especially when valuations look quite attractive in a relative context.
BlueBay Asset Management is a fund manager for St. James’s Place.
Where the views and opinions of our fund managers have been quoted these are not necessarily held by St. James’s Place Wealth Management or other investment managers and are subject to market or economic changes. This material is not a recommendation, or intended to be relied upon as a forecast, research or advice.
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