How do you see the world and the European economy?
Well, right now, clearly the economic outlook in Europe and elsewhere is stronger than most people expect, and the reasons for that are very clear. We have reached the limit of inflation, the energy crisis in Europe has been avoided (very important for the region and also for the whole world). Growth depends heavily on the expansion of the Chinese economy, which has become the main engine of the world economy. China came out of lockdown very suddenly and unexpectedly, which has fueled the suppressed consumption of its population. Europe has been a big beneficiary of that growth. However, the growth figures are still very low.
As far as the growth prospects are concerned, we expect it to turn negative in Europe and the US very soon. In fact, we suspect that the US economic outlook may now be worse than the European one, mainly because the pace of interest rate hardening has accelerated. The decline in the money supply has become more pronounced, and perhaps most importantly, lending standards in the US have become more stringent as a result of what is happening in the regional banking system. These are three compelling reasons to be wary of the development. Although they refer to America, they also apply to Europe.
And if you look at things like yield curves, the bond markets are telling us that they were very concerned about growth for a year. I think the curve reversed about a year ago. Generally this could mean that a recession could happen around this time. I think the bond market may be the one to fix that.
There are also several other forward-looking indicators. But another aspect that I find interesting is the historical comparison between core and headline inflation. When a reversal occurs, ie when core inflation begins to overtake headline inflation, it is usually a very negative sign about the health of the economy. And of course now it’s happening more or less all over the world because of the drop in energy prices.
We are seeing inflation above headline inflation and this does not bode well for the economic health as far as inflation is concerned. For our part, we still think that inflation will come down very sharply in the second half of the year, but we believe that core inflation will now be stronger than before.
It is quite clear that things like prices and services are going much better than expected. Obviously, it is the manufacturing and industrial sectors of the economy that are shrinking the fastest. And certainly we continue to think that oil and gas prices will come down sharply through the rest of this year as demand starts to factor into the economic equation.
We think headline inflation is coming down fairly quickly, but perhaps not enough to justify the level or pace of interest rate cuts, or at least the timing of the first cut.
For example, the US bond market suggests the first interest rate cut could happen as early as July. We believe they will remain high till the end of this year. We expect the Federal Reserve to cut rates later this year and the ECB for the first time early next year.
Have we already reached the ceiling on rates?
Yes, we think we’ll peak soon, probably in the next few weeks in both Europe and the US, but we think we’ll be there probably 6-7 months in the US and a little longer in Europe. So they are going to cut rates, but not that much. Well, I think they will cut pretty quickly when they start, but we think interest rates will continue to be higher than the market expects.
In this scenario, what is your view on the financial condition of the companies?
It really depends on what parts of the economy we’re talking about and the size of the companies. I think small people and individuals are going to come under significant pressure because we’re going to see the cost of debt increase dramatically and the cost of debt is going to start to rise very quickly, especially for people with large mortgages, But also with credit card debt. And that on a personal level for companies.
Smaller companies tend to have a shorter debt maturity profile when refinancing their debt. The cost of that debt is going up. Earnings are falling at the same time, which is a pretty terrible combination for high-performing companies, which is certainly the sector of the market I invest in.
In fact, companies very smartly issued huge amounts of debt between 2019 and 2021 and issued that debt at very low interest rates. Most of the loan was at a fixed rate, so it has a maturity profile of three or four years ahead, so the refinance risk is very low. The affordability of that loan is very high and the risk of default on those balances is very low. So we expect a default rate of 2.5 to 3% over the next 12 months, which is still very low by historical standards. The long term average in Europe is 4-4.5%.
But there is a problem that could crop up later. If yields and interest rates remain at these levels, companies will have to refinance a lot. Interest rates are twice as high as they are today. And that’s going to have a huge impact on cash flow and the health of the balance sheet.
Are we talking three years from now and Europe?
The peak debt maturity profile in Europe in most loans or high yield is in 2025 and then even more in 2026. Next year and 2025 are going to be big refinance years.
In the second half of next year we may be in an environment where interest rates are very low and the economy is coming out of recession, so yields may actually be lower than they are today. We probably think they’ll be a little short. So it may not be the worst refinancing environment. But we’re still talking about coupons that are going to be higher than they are today.
With all this on the table, is it a good time to invest in high yield debt?
Yes, we think the timing is right for European high yield. We believe this is a good moment to enter. We think the spread, meaning the return that we’re getting on the contribution to government bond yields, is probably still very, very low maybe 100 basis points. But we also think that the yield on government bonds will continue to decline. So we don’t think the return will be more than 8% even at the peak and we think the spread will be 500 to 600, maybe 650. And also, the yield on government bonds is probably very low. And at the same time, we believe that government bond yields will continue to decline during the course of the year.
Ultimately, I think valuations are fine for high-yield investors today. Maybe a slightly better entry point, but I always tell people to scale up. It is not necessary to buy everything at once. You can start buying today and if you start buying seven today at 7.5% and stop buying eight at 8.5%, your compounded interest rate is 8% and that’s great.
How do you see the ratings?
They’re good, but they’re not cheap. In short, I don’t think they’re cheap, but I don’t think they’re insanely expensive either.
How is your fund’s distribution distributed in terms of geography, duration, ratings…?
We’ve positioned ourselves quite cautiously at this point for the reasons I’ve stated: that is, the real economy, the growth outlook, and the impact that’s going to have on earnings and, as a result, leverage. So in that context, we are positioned defensively by region.
We are overweight in the most defensive sectors, such as healthcare, telecommunications, media, our utility companies, gaming companies, defensive sectors of the market, and we are underweight in banks. But we thought the valuation of the bank was too high.
Also, inverted yield curves are not good for banks. Everyone talks about high interest rates being good for banks and it is true to some extent, but inversely decreasing yields are not good for them. In other areas we’ve gone down the energy path, we were very overweight last year. And we are very cautious in the consumer and real estate sectors.
From a credit rating perspective, we are now in line with the index rating, so we have a lower average rating of Double B, which is in line with the market, and we have increased the fund’s quality profile. So this year we sold single B and triple C bonds and bought double B and investment grade bonds. We have bought some Treasuries and we have also bought some security. So we have a small hedge in the fund to protect against spread widening that we think is going to happen over the next couple of months, three or four months.
Finally, from the perspective of countries, the weight per country is always the factor we think least about. We are somewhat agnostic, not completely agnostic, but we are fairly agnostic within Europe.
But today we are slightly fatter than America, Britain and Spain. Interestingly, the US and Spain are far more self-sufficient in energy. We weigh less than Germany and France. We are also underweight Italy.
Just a note, if we’re talking about the US, it’s because US companies issue in Europe, even if we’re talking about the European High Yield Index.
For investors looking to invest in European High Yield Funds, what is the difference between your fund and other funds in the same category?
I think a few things are; The first is that I have been managing the fund for over 11 years, so I have been the lead manager of this particular fund longer than probably anyone else in the European market for these types of funds. On the other hand, the long-term performance is really great and we’ve done very well over the last three or four years. It has been very satisfying to be able to perform very well in the toughest of markets as well as in the strongest. I think the reason for the good results is the quality of the team. You know, we have over 100 years of combined experience.
But I think most of all when you ask us what sets us apart, what sets us apart is that we are committed to outperforming the market throughout the cycle.