Base case
MFS’ base case continues to be a recession in the U.S. and expects that a soft-landing scenario will be particularly challenging to achieve, said Gomez-Bravo, also co-portfolio manager for global multisector fixed income and credit.
She pointed to two indicators, with the first being unemployment. “It is very difficult to manage a loosening of the labor market, which is what the Fed is looking to do, without generating unemployment,” she said. Moreover, it is a lagging indicator. “By the time you start seeing unemployment go up, you’re already in a recession, usually.”
The second is corporate defaults. “We’re starting to see a significant increase in bankruptcies,” Gomez-Bravo pointed out. While they don’t account for a significant amount of market value yet, in terms of defaulted debt, it is likely higher rates will result in rising defaults that can impact the wider markets. “Spread markets and equity markets significantly suffer from drawdown risk,” she noted.
Like the protagonists in the play “Waiting for Godot,” investors seem to be constantly waiting for the Fed’s next moves, Gomez-Bravo said, but its position seems evident: “The Fed, like central banks in other developed markets, will have to hold policy in restrictive territory,” she said. The U.S. is still seeing positive growth indicators, so it’s unlikely that unemployment and defaults will increase over, say, the next six months. But given the Fed’s continued restrictive path, “the very tricky art of landing in the U.S. probably leads to a recessionary outcome.”
Forward indicators
“All in all, the U.S. stands out as the cleanest shirt in the dirty laundry basket around the world, but that doesn’t say much,” Gomez-Bravo said. Most central banks, including in the U.S. and Europe, are closely focused on combating inflation. They are looking at lagging indicators, such as inflation and unemployment, rather than looking forward. “Europe is clearly seeing a significant growth slowdown ahead,” she said, noting that Germany is already in that situation. China is facing a number of short-term growth challenges, with muted policy response, and its central bank probably has less room to maneuver, given the prospect of a balance-sheet recession, she noted.
As investors look to decipher the economic tea leaves in the U.S., the MFS team is focused on two forward indicators. “One is U.S. jobless claims, whose moving average is a pretty good indicator of where labor markets are going. That is still holding up well, but that would show the first inklings of a weaker labor market,” Gomez-Bravo said.
The second is credit conditions for banks, as they are not out of the woods after the March 2023 regional banking crisis, she added. “Focusing on the financial condition of banks, their funding costs and credit creation, via data such as senior loan officer surveys, is going to be paramount to understanding where the economy ends up.”
Whatever the near-term recessionary impacts of the current inflation cycle, fixed-income investors should keep in mind that the developed markets could face structurally higher inflation ahead. Gomez-Bravo cited a number of inflationary tailwinds: demographic trends of aging populations and the impact on labor supply; onshoring in the context of national security concerns; and green investing and net-zero initiatives. “When we start having a view on where the curve may go, we need to price in that higher-inflation environment,” she said, with above 2.5% as a viable estimate given current conditions.
Get diversified
“Our mantra is that when you have a high degree of uncertainty, diversification is your best friend,” Gomez-Bravo said. “For us, a broader fixed-income approach to risk management and portfolio construction means being very thoughtful about the role of duration relative to credit risk.”
“As asset owners look at the landscape in fixed income today, it warrants a reconsideration towards publicly listed fixed income,” which provides higher yields and income, Gomez-Bravo said. That’s very different from the low-yield environment of a few years ago, which drove many investors to the high-risk private markets in search of returns. Public fixed income can “now fit different outcomes for asset owners, whether it’s income, capital protection or diversification, you’re likely to find something that fits those needs. Also, it will give you liquidity,” she said. “That’s something not all pension funds need, but at the margin, why not have it when you can get decent yields as well?”
Balancing opportunities
Depending on investors’ risk-return objectives, MFS’ fixed-income team looks for relative-value opportunities in curves and countries for global fixed income. It looks to combine a longer-duration approach with selective allocations within some risky assets and fixed income. For instance, investment-grade credit is in “a bit of a sweet spot, although it’s not as attractive relative to where it was a year ago,” Gomez-Bravo said, “with U.S. spreads at round 120 basis points and European spreads in the 160s.”1 European credit, in general, has better valuations and tends to be in larger companies, which provides more resilience in a downturn, she pointed out.
Another interesting area to consider is mortgage-backed securities, where high-quality paper offers good convexity, she said, meaning the relationship between bond prices and bond yields. The sector has seen poor technicals due to selling by the regional banks earlier this year and commercial real estate concerns. “Frankly, it is a way of selling volatility. As inflation outcomes narrow, it’s not a bad thing to be able to sell volatility and rates, which only mortgages will do.”
The MFS team is avoiding high yield in certain strategies, not surprisingly, as it is highly correlated with equities, and valuations aren’t as attractive, she said. “To the extent you own a smaller amount of high yield, we’d favor being very, very selective at the front end of the curve,” Gomez-Bravo said. Also, the firm prefers U.S. investment-grade corporates over emerging-market investment grade. “Why take that extra risk on EM, which has a lot of speculation as well? It’s better to be a bit more defensive.”
Three C’s
To deliver active management with conviction through the markets, the MFS fixed-income team follows “the three C’s,” said Gomez-Bravo. The first “C” stands for collaboration that creates structural connectivity among its different investment teams. “When you’re navigating new regimes and uncertainty, having a more nimble approach to deliver outcomes for clients relies on our collective intelligence,” she said.
The second is consistency, in both investment process and seeking alpha through the cycle. “It is a key focus for allocating capital responsibly on behalf of our clients” through the investment process, portfolio construction and risk management.
The third is conviction. That is “when there are dislocations in the marketplace that [an asset manager] can take advantage of in asset allocation or security selection and can use the risk budget to seek alpha for the long term,” Gomez-Bravo explained. “Conviction is what differentiates an active fixed-income asset manager” in the delivery of a robust and dynamic investment approach, she added.
To deliver the three C’s, MFS pursues a “portfolio management structure that allows us to have a broad view, and we think that diversity of thought is very important,” Gomez-Bravo said. The fixed-income team also “works very closely with our in-house risk team, along with our clients’ teams, to stress-test each portfolio,” she said. The fixed-income team also maintains a close relationship with the equity team, which helps produce a more holistic view of risks and returns across issuers. Finally, the firm’s rigorous 360 peer review process and compensation framework support the focus on long-term performance for its clients. ■
