In this analysis, Benoit Anne, Managing Director, Strategy and Insights Group, MFS Investment Management, shares his thinking on how asset managers can hedge the US election risk, spread dispersion and euro credit.
Tactically hedging the US election risk.
The US elections are just two weeks away, and this could potentially trigger a renewed wave of market volatility. One of the best hedges against higher election risk could well be being long the US dollar. Ignoring the election risk, there are many drivers that may lead the US dollar to weaken going forward. This includes the possibility of more aggressive Fed easing than currently priced in, a further improvement in the global risk appetite backdrop, or an upgrade in global growth expectations, all possibilities in the period ahead. But the US election may possibly bring out other factors, which this time could be dollar supportive. For instance, an increase in trade tariffs will likely help the dollar strengthen, especially as targeted countries will probably engineer some weakness of their own currency as a move to offset the tariff impact. Likewise, a potential escalation of geopolitical risks may also cause the dollar to appreciate going forward. On a domestic policy front, the perception that fiscal policy will become even more expansionary may push market rates higher, with positive repercussions for the value of the USD. Similarly, the Fed may be tempted to slow down the pace of its future rate cuts, if they believe that the US economy is at risk of shifting back into overheating mode. That also would be supportive of the US dollar. Overall, our fixed income portfolio managers are likely to be facing a highly volatile market backdrop in the near term, which we believe is going to present some risks but also some opportunities.
Manager skills required.
Credit spreads are rather tight these days, especially when looking at US IG credit. Not only that, but spread dispersion, which measures how wide the spread range is within the index, is also back to being well below its historical average. This is when skilled managers have an opportunity to shine, because generating security selection alpha in the face of tight dispersion becomes a higher-skilled business. You see, when spread dispersion is very wide, it means that there are a lot of valuation dislocations, and everybody has a good chance, with security alpha generation being a lower-bar challenge. Not this time however, in our view only asset managers with a highly developed global research platform and a strong bottom-up investment process will be able to make an impact these days. When expectations for credit returns, especially the component of total returns coming from spread compression, are less favorable, alpha, i.e. the excess return above the benchmark return, is going to matter a lot more. In a nutshell, this is alpha time for credit. Of course, besides alpha, there is also duration and the attractive carry, which we believe overall make up robust expectations for fixed income total returns in the period ahead.
Euro credit still supported by strong technicals.
According to our EUR credit portfolio manager, Andy Li, there are two main drivers that are positive for EUR credit: technicals, and relative valuation. On the technicals side, inflows into the asset class have been robust, and there are good reasons to think that this may remain the case, especially with the ECB easing cycle under way. As for valuation, the backdrop favours EUR Credit relative to the US, where spread valuation appears to be quite stretched. Furthermore, it is also worth noting that EUR credit fundamentals continue to be solid, despite the challenging growth backdrop in the region. With that in mind, our EUR credit portfolio management team is constructive medium-term on the asset class. In the near term, however, there are global risks on the horizon, which warrants a more cautious bias from the standpoint of spread dynamics. Andy Li is therefore cautiously constructive for now, and he stands ready to take advantage of renewed volatility in global markets. From a longer-term perspective, the total yield valuation—or even better, the break-even yield valuation—continue to look favorable.
