KEY TAKEAWAYS

  • Since its inception in 2010, the MAC strategy has sought to maximize income and expected total return within a specified risk budget by providing diversified exposures to higher-yielding asset classes globally.
  • The MAC strategy has been able to recoup 2018’s underperformance by maintaining its highest conviction holdings in high-yield and investment-grade corporate credit and EM local markets, as well as by adhering to its diversified strategies approach by keeping exposure to structured credit, bank loans and DM bonds.
  • We currently see compelling investment opportunities in high-yield given the sharp spread-widening during 4Q18 and in EM, specifically local-currency-denominated debt.
  • Western Asset’s macro expertise has been the foundation of the success of our global credit teams and also stands on its own as an important alpha driver.
  • In the current market environment, investors who have a long-term horizon and are looking to generate high returns should avoid being seduced by the appeal of esoteric asset classes, highly concentrated sector-specific strategies or any strategy that would only work in a single macro scenario.
  • Looking ahead, we see the demand for income solutions such as MAC growing in line with the global demand for income.

How did the MAC strategy fare during a year of extreme market volatility?

MB: There’s no question that 2018 was a tough year. We thought the synchronized global growth momentum in place since late 2016 had more room to run with the US posting a moderate 2.0%-2.5% annual growth rate and European growth remaining steady after a solid 2017. However, our expectations were completely upended by the two-punch combination of increased euphoria around US growth estimates due to the effects of the 2017 tax cuts and increasing pessimism around Europe and emerging markets (EM) due to growing fears around Brexit, a China slowdown and the threat of a global trade war. The divergence between US and non-US growth not only persisted throughout 2018, but also expanded, which pushed the US dollar, US interest rates and risk premia higher across spread sectors globally. This cocktail of risks weighed on MAC performance throughout 2018.

In December 2018, the diversification benefits of our long US duration positioning kicked in as US Treasury (UST) yields declined sharply on the back of dovish rhetoric from the Federal Reserve (Fed) and an aggressive shift in market sentiment to the downside around US growth prospects. During the more turbulent days in December—when global equity markets began to crack and spreads across high-yield and investment-grade corporate credit started to widen dramatically—we took advantage of this extreme market pessimism to add risk selectively across MAC portfolios.

Looking at where we are today, I think it’s fair to say our patience and tactical positioning paid off. We’ve been able to recoup last year’s underperformance by sticking to our high conviction calls in high-yield and investment-grade corporate credit and EM local markets, and by adhering to our diversified strategies approach by maintaining exposure to structured credit, bank loans and developed market (DM) bonds. Our conviction in our portfolio holdings is based on the view, which we cover in more detail in our 2019 Global Outlook, that global growth will remain positive in 2019 as US growth moderates slightly and as Europe and EM, buoyed by China and the Asia-Pacific complex, regain their footing. We acknowledge that there are plenty of risks that may challenge this view, such as a collapse in the US-China trade talks, more tensions between Italy and the EU as well as the UK separating from the EU via a “hard Brexit.” The market, however, is pricing each of these scenarios for extremely negative outcomes.

Exhibit 1: Multi-Asset Credit Performance and Relative Risk Profile
(A) Source: Western Asset. As of 31 Jan 19. Returns for periods greater than one year are annualized. Please see the Risk and Performance Disclosures for more information.
Past performance is not indicative of future returns.
(B) Source: Bloomberg Barclays, J.P. Morgan, Western Asset. As of 31 Jan 19.
*Incepted 01 Oct 10. The Multi-Asset Credit Composite is not measured against a benchmark. There is no benchmark available which appropriately reflects the strategy.
US Investment Grade Credit is represented by Bloomberg Barclays U.S. Credit Corporate Index. US High Yield is represented by Bloomberg Barclays U.S. High Yield Index.
USD Emerging Markets is represented by JPM Emerging Markets Bond Index Plus (EMBI+).

What do you view as a top risk for global markets in 2019?

MB: The US-China trade conflict is at the top of the list. So far, the brinksmanship between both countries has introduced tremendous uncertainty to the global economy and weighed on asset prices across EM in particular. While there’s always hope that some definitive resolution in trade can be reached between the two countries, we take some comfort from a few of the recent moves that China has taken to address some of its domestic vulnerabilities, which could harm broader market sentiment if left unchecked. For instance, rather than pursuing their deleveraging campaign, Chinese officials have instituted reserve requirement reductions, targeted fiscal spending increases, individual tax-rate cuts and a renewed emphasis on providing credit to the private sector. This suggests that the slowing momentum we’ve observed more recently may reverse over the course of the next several quarters.

That said, there are wide-ranging views among market participants regarding what constitutes a reasonable pace of growth. We would not be surprised if China’s annual GDP growth trajectory moderates to 6.2% and 6.0% in 2019 and 2020, respectively. However, we don’t view this as apocalyptic: a 6% expansion today has a far greater impact on global GDP than 10% did in the early 2000s. More importantly, our view is that a measured pace of growth including domestic consumption, improvements in information technology and high-end manufacturing is in China’s long-term interest. While this is not a bullish scenario, our expectation is that at a minimum it would reduce the tail-risk of an extreme China meltdown.

Looking away from China, we’re keeping a close eye on developments in Europe and Japan where growth and inflation estimates continue to move lower. Recent weaker economic data out of Germany, France and Italy, combined with fears of a recession in the US, could increase the odds of a more synchronized global slowdown. Such a scenario would certainly unnerve global markets and weigh on the MAC carry trade.

Given your broader macro view, how are you currently positioned in MAC?

MB: Since the inception of the MAC strategy, we’ve always emphasized two points: the need for diversified strategies so that no single strategy dominates portfolio returns and the importance of active sector rotation to drive alpha in a diversified portfolio. This investment philosophy has served us well during both strong risk-on and risk-off markets.

For instance, high-yield represents an important income-generating sector for our portfolio. However, given the sector’s impressive run over the past few years, against a backdrop of rising US rates, energy price volatility and tighter liquidity, we’ve been methodically recalibrating our risk exposures by leaning toward higher quality issuers (such as “rising star” stories which are BB rated credits that have the potential to move to investment-grade over the next 12-18 months) and rotating across the various high-yield subsectors, such as financials and metals and mining, to find those industries and securities that we believe offer the best risk-reward potential.

In the investment-grade space, we’re focused on subsectors or industries that are not in a position to re-lever or where bondholders might be impacted by M&A and other shareholder-friendly activities. For example, we continue to like the energy sector and the metals and mining industries as they are still undergoing balance sheet repair and have benefited from the current rally in commodity prices. We also continue to like financials as we’ve moved past the period of stupendous fines, because regulations such as Dodd-Frank and the Basel accords will keep banks from re-levering, and the recent rise in short-term rates should continue to provide the cashflow many investors have been expecting.

Structured credit is another important part of our program. We appreciate the lower correlation that non-agency residential MBS (NARMBS) and commercial MBS (CMBS) have to corporate credit and are looking to opportunistically add to BB/B rated parts of the capital structure in deals where we can participate in a more significant structuring role. At present, we have a favorable view of valuations in credit risk transfer deals in the NARMBS space and single asset-single borrower securitizations in the CMBS space.

At present, we see compelling investment opportunities in high-yield given the sharp spread-widening during 4Q18 and in EM, specifically local-currency-denominated debt. In our view, 2018 was another perfect storm for EM; idiosyncratic risks, UST yields and geopolitics all put substantial pressure across the EM fixed-income complex. However, we continue to believe that EM fundamentals remain resilient and that valuations and technicals should not be overlooked, especially when viewed through the lens of the recent past. Consider the following statistics: index yield spreads between EM debt and DM debt are near 2008 and 2016 wides; currency levels are 35% lower than just five years ago, and the real yield of EM debt is at a 15-year wide versus the real yield of DM debt. While the path to improving risk sentiment may well still be volatile, we think EM is the most undervalued asset class and, as January has already demonstrated, will continue to grind higher as global risks recede.

Exhibit 2: Holdings by Sector
(A) Source: Western Asset. As of 31 Jan 19. Past performance is not indicative of future returns.
(B) Source: Western Asset. As of 31 Jan 19. All percentages are relative to market value.
The information provided is supplemental to the Multi-Asset Credit Composite. Please see the Risk and Performance Disclosures for more information.

What has contributed to MAC’s success over the past eight years?

RA: I think the key to MAC’s success is its ability to fully leverage Western Asset’s global investment capabilities. The Firm has over 45 years of fixed-income experience with a platform that spans seven investment offices across five continents. We have specialized sector teams including Global Investment-Grade Credit, High-Yield Credit and Bank Loans, Structured Products and Emerging Market Debt. Each team comprises battle-tested portfolio managers and traders, in addition to more than 100 research analysts with an average of 20+ years of experience covering their specific companies, industries and regions. Our expertise in the macro side of the equation has been the foundation of the success of our global credit teams and also stands on its own as an important alpha driver. Having a strong understanding of the drivers of yields, the forces shaping inflation and the trends influencing economic growth and currencies is critical. The views of our macro team not only impact credit allocation decisions, but also directly influence our duration and yield-curve positioning across markets.

Another key factor that has contributed to MAC’s success has been the way risk management complements the management of the strategy. On a daily basis, we use models produced by the risk team to ensure the risks that we are actually taking in the portfolio are the ones we indeed intend to be taking. If a mismatch arises, then we can quickly make an adjustment. We run scenario analyses on both anticipated market events (e.g., Brexit, China slowdown) and historic events (e.g., a severe spread-widening such as the great financial crisis, or the taper tantrum) to get a picture of the possible impact on our holdings. While our risk team does not function as the “portfolio police,” it does help us elevate our game by keeping us quite aware of the “what-ifs” and making sure we are keeping our focus where it should be.

Looking at MAC through the lens of risk-adjusted performance, we believe its Sharpe ratio of 1.24 since inception eight years ago is a strong testament to our Firm’s investment and risk management capabilities.

Why do you think MAC is relevant in today’s environment and going forward?

RA: As we discussed in a recent paper, Embrace the Power of Income, we believe income generation via global credit in all of its forms—corporate debt, structured credit and government debt to name a few—will become an increasingly integral part of investor portfolios and that active sector rotation will be essential. Bear in mind that credit sectors don’t necessarily move in tandem; they have different cycles, and they do well in different markets. Therefore, the ability to tactically emphasize one sector and de-emphasize another to find value and drive alpha in a diversified portfolio will be vital for performance. This is the essence of what we try to do in MAC.

In the current market environment, investors who have a long-term horizon and are looking to generate high returns should avoid being seduced by the appeal of esoteric asset classes, highly concentrated sector-specific strategies or any strategy that would only work in a single macro scenario. This ultimately exposes them to more drawdown, volatility and liquidity risk. This is why MAC emphasizes a multiple diversified strategies approach so that no one strategy dominates performance.

Looking to the future, we see the demand for income solutions such as MAC growing in line with the global demand for income. Populations are aging across North America, Europe and Japan, and biomedical advances continue to extend life expectancy rates globally. This will have profound, long-term implications on how individuals, businesses and governments think about savings and investment.

We also have to consider secular forces such as the impact of rising debt levels on global growth and continued advances in technology and innovation which will likely depress the long-term path of interest rates. Today’s low interest rate environment has left those on the verge of retirement playing catch-up with their savings, while pensions and insurance companies are challenged with identifying more attractive sources of income-generating assets to meet their future cashflow needs. We believe this challenge will become even more acute in the coming years, leading to continued demand for fixed-income to act as an income and return generator as well as a diversifier against equity risk in a broad investment portfolio.

These are just some of the reasons why we think our MAC strategy will remain highly relevant for the foreseeable future.

View the Performance and Risk Disclosure for Multi-Asset Credit.