- Fixed Income and Global Insurance Strategist
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Hong Kong (香港), Individual
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In this episode of InvestorExchange Podcast, Fixed Income Portfolio Manager Connor Fitzgerald joins host Amar Reganti to discuss the potential effects of tariffs and other fiscal decisions on the bond market.
Below is the excerpt of the full episode:
What are the key challenges facing the US administration?
The US administration faces two main challenges:
- Cutting spending at the federal government level: The administration aims to reduce federal spending, which is crucial for managing the budget and deficit.
- Raising revenue via tariffs: The administration plans to increase revenue through tariffs.
Both of these challenges are significant because if not managed carefully, they could lead to a recession, which would dramatically expand the deficit and negate efforts to cut spending and raise revenue.
What are the impacts from tariffs?
Revenue generation: Tariffs have not been a significant source of revenue in well over a hundred years, indicating that relying on tariffs to balance the budget may not be effective.
Foreign investment: Tariffs have impacted foreign investment into US assets. Fitzgerald notes that the administration underestimated the impact of tariffs on foreign investment, which has led to a decline in foreign ownership of US Treasuries from about 50% in 2018 to closer to 30%. This reduction in foreign investment could lead to higher yields as the government may need to offer more attractive rates to attract buyers.
Capital account flight: If the administration is too aggressive with tariffs, it risks losing foreign investment, which is crucial for funding the deficit.
What are the implications for US Treasuries and US economic outlook?
Deficits and government debt: The significant size of US deficits and the increasing government debt are highlighted as major concerns. This trend has led to worries about the sustainability of current levels of borrowing and the potential impact on Treasury yields.
Term premium: Fitzgerald discusses the concept of term premium, which is the additional yield investors require for holding longer-term securities. He believes that the increase in term premium is a structural trend that will continue, driven by factors such as the need for duration by pensions and insurance companies, and the long-term impact of quantitative easing.
Inflation and real yields: Higher inflation expectations can lead to higher nominal yields, while real yields reflect the long-term growth potential of the economy. He suggests that real yields of around 3% are not overly restrictive and that the long end of the Treasury curve may see higher yields due to supply-demand imbalances.
Market sentiment and economic outlook: Fitzgerald suggests there is a high probability of a recession, but the overall impact may be less severe due to the financial strength of corporations and households. He does not think there will be significant fiscal policies to support the economy; and for monetary policies, while the Fed can cut rates, it’s unlikely that we will see zero interest rates again.
What to look out for in terms of asset allocation?
Reassessing duration: Fitzgerald suggests that the concept of duration as a hedge may not work as well as expected in the current environment. He mentions that if you thought you needed two years of duration to hedge your portfolio in five-year notes, that might be four years on a forward-looking basis. This implies that investors may need to reassess their duration strategies and consider longer durations to effectively hedge their portfolios.
Impact of potentially steeper Treasury curve: Fitzgerald expresses high conviction in a steeper Treasury curve in almost any outcome. He believes that if the administration's tax plan goes through, the long end of the Treasury curve will sell off potentially aggressively. This suggests that investors should be cautious about holding long-term Treasuries and consider the potential risks of a steepening curve.
Value in high yield: Despite the challenges, Fitzgerald sees value in certain parts of the high-yield market. He mentions that there are parts of high yield now yielding 8% to 9%, which, while not without risk, offer attractive returns if investors can pick companies that don't default over a two- to three-year horizon. Investors may find opportunities in high-yield bonds, especially if they are selective and manage risks carefully.
Liquidity: Fitzgerald believes that capital and liquidity are crucial in the current environment, as they provide the flexibility to deploy assets at attractive levels in the coming 6 to 12 months. Investors should prioritize maintaining liquidity to take advantage of potential opportunities and navigate challenging periods.
Recession Risk: Fitzgerald acknowledges a high probability of a recession, although he does not expect it to be cataclysmic. He believes that corporate and household balance sheets are strong, which should mitigate the severity of the recession. This implies that investors should be prepared for a potential economic downturn but may not need to take extreme defensive measures.
