What Fed’s pause means for investors

<p><strong>Glenn Freeman</strong>: In this edition of "How We Invest Your Money" I'm speaking to Brendan Murphy from Mellon.</p> <p>Brendan, thanks for your time today.</p> <p><strong>Brendan Murphy</strong>: Great. Thank you.</p> <p><strong>Freeman</strong>: Now, we are speaking about fixed income and obviously, we've heard a lot in recent times about the equity markets. Fixed income tends to have been glossed-over a little bit. Now, probably one of the biggest events in this space that's happened recently is the U.S. Fed having paused on rates. Now, what does this actually mean for the broader fixed income sector, for the credit space and for investors there?</p> <p><strong>Murphy</strong>: Yeah. I mean, it's been a big relief for risky asset markets. Our belief is the Fed is on pause for an extended period of time. We don't think they are necessarily done in terms of the rate tightening cycle.</p> <p>But certainly, equity markets and the riskier parts of the fixed income markets came under a lot of pressure in the fourth quarter last year around concerns that the Fed was going to tighten maybe more than expectations. So, the fact that they paused at this point is really eased financial conditions and help those riskier assets perform well.</p> <p><strong>Freeman</strong>: So, what's your expectation for the remainder of 2019?</p> <p><strong>Murphy</strong>: Yeah. So, our belief is that the Fed is not done, and that they are going to resume the tightening cycle. But that's been a bit delayed.</p> <p>So, we look for the Fed to raise two more times this year in September as well as in December. And that's based on the belief that the U.S. economy is likely to stabilise over the next few quarters. And with that, mainly over concerns around the possibility of price pressures emanating that the Fed would look to put in two more rate increases.</p> <p><strong>Freeman</strong>: And how does this play into the types of credit securities that you prefer right now?</p> <p><strong>Murphy</strong>: Yeah. So, I think, we've got a very narrow window where you could see credit perform reasonably well. You could see risky assets perform reasonably well. But we would view that more as an opportunity to get more defensive in terms of the portfolio positioning. Because ultimately, as the Fed comes back onto the table in the later part of the year as we expect, that could introduce more volatility into the markets.</p> <p>So, we are looking at ways to increase the credit quality of the portfolio as well as the liquidity profile of the portfolio. So, moving up in quality in terms of the credit ratings, moving from unsecured credits to secured credits. Basically, moving up in quality.</p> <p><strong>Freeman</strong>: Can you talk about some of the specifics there in terms of, say, how your exposures to emerging markets debt or sovereign debt has changed?</p> <p><strong>Murphy</strong>: Sure. So, generally speaking, well, starting with high-yield credit, for example, it has been an area of the market that we had very low exposure. We have taken that exposure down throughout the course of 2018. Investment-grade credit, similarly, we've taken that exposure down. Emerging market debt, we've reduced the exposure on the margin but it's still one of the parts of the market that we are a little bit more constructive on. Part of that is based on the belief that the U.S. dollar is likely to weaken over the next few years which is the belief that we have. We think that that should supportive of emerging market debt overall. But generally speaking, we have been reducing the overall credit risk in the portfolio.</p> <p><strong>Freeman</strong>: Speaking more generally in terms of the broader global macro environment, how should investors position their portfolio in terms of the fixed income assets?</p> <p><strong>Murphy</strong>: Yeah. So, I think &ndash; well, I think, first and foremost, diversification is key. I think we've gone through a period where central banks have been very accommodative. Now, that led to low levels of volatility in the markets. And we're entering a period of, I think, &ndash; last 2018 was a good example of a period in which volatility is likely to increase.</p> <p>So, as that liquidity is withdrawn from the system, as central banks look to tighten policy more and more, that could potentially lead to greater volatility in the markets. And some of that is idiosyncratic in nature. We saw that last year in emerging markets in places like Argentina and Turkey and some of it's a bit more systematic and we saw that with U.S. high-yield, for example, which sold off significantly at the end of last year.</p> <p>So, I think diversification, first and foremost, is important. I think having an emphasis on liquidity in your portfolio is also important. Sometimes these dislocations in markets can present tactical opportunities and that liquidity benefit for your fixed income manager is going to be essential.</p> <p><strong>Freeman</strong>: So, with that sort of returning volatility it sounds like &ndash; would you say that the role of fixed income is possibly becoming even more important now &ndash; people might have overlooked it a bit more in recent times. But is it becoming more important for diversification now?</p> <p><strong>Murphy</strong>: Yeah. Absolutely. I think people &ndash; the significant amount of intervention that we've seen from central banks depressed, developed market government bond yields depressed cash rates to levels that made fixed income relatively unattractive as an investment destination.</p> <p>We've seen yields move a little bit higher, which all else qual, makes them look more attractive. And the fact, in the U.S. right now, you can get 2 per cent-ish yields with relatively little risk, that's very different than the environment we were in a number of years ago.</p> <p>So, having a diversified high-quality fixed income portfolio I think can act as a very strong balance to your portfolio and is an important consideration in overall asset allocation.</p>