Ana Otalvaro (Axa IM): “Short-term debt loses its shine and we doubt future returns” | Financial markets

The last mile to achieve the 2% inflation target is still elusive and central banks have been forced to reconsider the pace of rate cuts. Fixed income, which was set to be the star asset of 2024, is failing to take off. In a context in which political uncertainty is seen as a threat to price stability, Ana Otalvaro, portfolio manager in the interest rates and inflation team at Axa IM, sees inflation-linked bonds as the most attractive option. With 14 billion euros under management, the expert expects the divergences between monetary policies to fade as the year progresses.

AskThe ECB, in line with other central banks such as those of Canada and Switzerland, has already begun to lower rates. How many cuts are expected?

Answer. The objective involves a convergence of inflation to 2% accompanied by less pressure within the labor market because a certain reluctance to lower rates has been due to the fact that the labor market is a little tense. The forecasts we manage at Axa IM point to two rate cuts by the ECB in the second half of 2024, followed by another two in 2025. This is accompanied by a Federal Reserve that we believe will lower rates twice this year, once in September and another in December, and four next year. We hope that there will not be such a pronounced divergence with respect to the monetary policy of developed countries. As inflation and the labor market show less strength, central banks will have more confidence and investors will increase their exposure to fixed income.

Q. UK inflation fell to 2% in May. When will it be reached in the eurozone?

R. The fact that we have achieved this does not mean that the battle against inflation in the United Kingdom has been won. The 2% recorded by the headline rate is a bit of an optical illusion. Much of this is due to the energy component, which represents between 7% and 10% of the household basket in developed countries and has a volatility of two thirds. Central banks are focusing on the core rate, which excludes energy prices and is the one that really gives an indication of the behaviour of demand. This rate stood at 3.5%. The fall is less pronounced. The forecasts that we handle at Axa point to average inflation in the US this year being 3.5% and falling to 2.5% in 2025. For the eurozone we expect it to be 2.5% this year and 2.2% next year. Central banks do not wait for it to fall to 2% to lower rates, but what they want to see is a downward trajectory.

QDo you think political events can change the course of action for central banks?

RCentral banks are completely independent entities and their decisions should not be directly influenced by the political environment. What is much more likely is that certain government programmes, if implemented, could have an impact on inflation. In that case, central banks would have to react differently. Inflation risks are oriented to the upside.

P. What are those risks?

R. First the change in the political landscape. A few months ago the focus was on the United States with a program like Donald Trump’s that probably involves more protectionist measures. If we saw those initiatives implemented, there would be a risk of goods inflation. The proposals of the Labor Party in the United Kingdom or of Marine Le Pen’s party in France implicitly imply a greater fiscal stimulus that results in higher inflation. Added to this are the geopolitical tensions in the Middle East, which may have an impact on the price of energy. Another factor is the transportation of containers. On the route from Shanghai to Rotterdam we have seen that container prices have increased considerably. If these prices remain high for a long time, they will have an impact on inflation. Finally, there is the energy transition. It is expected that green energies can be produced at a lower cost, but the transition requires taxes on fossil energies to reduce their consumption. In the short term we do not have sufficient clean energy production power, which may end up generating inflationary pressures.

PHow are you managing these risks in your portfolios?

R. We continue to see interesting opportunities in fixed income. There are two instruments: classic bonds, whose returns increase as rates fall, and inflation-linked bonds, which have a portion of their income linked to inflation. In addition to benefiting from the rate cut, they are an interesting option for an investor seeking to hedge the inflation risk in their portfolio. If inflationary risks materialize and central banks do not lower rates, inflation-linked bonds will not be able to benefit from the fall in yields, but they will benefit from the increase in prices because the level of indexation will be higher. The inflation-linked bond index has a return of -0.94% for the year, compared to -1.56% for global debt.

QIs it time to increase portfolio duration?

R. The money market and very short-term debt have had high levels of profitability, but now that banks are starting to lower rates, reinvestment risk is emerging. Short-term debt loses its shine because we doubt future profitability in a context of lower rates. We think it is interesting to start adding duration. In the current context of an inverted debt curve (short terms pay more than long ones) we like the two, three and five-year maturities the most.

P. What are your preferred markets?

R. The universe of inflation-linked bonds is purely sovereign issues. We have a preference for the Eurozone because we believe that, although the economy has shown signs of resilience, it has been less than that of the United States. Secondly, we like UK debt and we have been adding duration through US sovereign debt because we think that the Fed will not take much longer than the rest of the central banks to lower rates.

Q. And in the universe of corporate debt?

RWe have very low exposure to corporate bonds and, although the options are quite diversified, we show greater interest in banking. All our corporate debt investment is in investment grade because the premium levels for high-risk debt are not attractive.

P. Could the rise in sovereign debt yields lead to a crisis like the one experienced in 2012?

R. For now we are not in a situation like that of 2012, but everything will depend on the electoral results and how the governments, once installed, apply the promised measures. Because ads are one thing and what they can do is another. Some training programs have recognized that they will not be able to immediately apply their programs.

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