The head of fixed income at a $221 billion fund manager tells us what he thinks about the bond markets in 2017
Toms is a 23-year industry veteran and 8-year veteran of the firm, which has $221 billion in assets under management.
In the interview, Toms discusses asset allocations, Trump's proposed repatriation of overseas dollars, and the sell-off in Treasurys.
This interview has been edited for clarity and length.
Tina Wadhwa: Wall Street analysts have been writing a lot about about a great "rotation" in markets, where investors are shifting their asset allocations away from bonds and into stocks. What is your view on this rebalancing, and do you expect it to continue?
Matthew Toms: We think that there are different types of investors and some are more structurally exposed than others to bonds or stocks. We think there has actually been a general aversion to bonds given their low yield for some time. To see a meaningful exodus would necessitate an over exposure or large exposure, and we just haven't sensed a huge inflow to begin with.
You can definitely see there has been a outflow, particularly on the mutual fund side, where the flows are more easily tracked. You have had outflows from bond funds and into riskier products such as equities helping to fuel that rally. Within that segment of the market, that's definitely true. That said, we do think that you have an institutional buyer base, particularly large financial institutions, pensions, insurance companies, or banks, who enjoy a steeper and higher yield curve and who can more than offset that move size wise.
So definitely for one component of the market, the more mutual fund and retail investor related, we do think there is some asset allocation. That said, we think that's not likely to be particularly long lasting as we don't think they were particularly overexposed to bonds going into this move.
Wadhwa: For the retail investors and mutual funds that have been moving their money into equities, how will political and economic uncertainty both domestically in terms of Trump's policies and abroad given European elections impact investors' strategies? Do you think the potential resulting volatility will lead investors to shift back into bonds or do you think this trajectory of moving money into equities will continue?
Toms: I think it's predicated upon the next steps. We think you've seen the majority of the moves in bond yields in our opinion. You still have relatively low inflation and relatively low potential growth levels around the world. What we need to see now are the actual benefits from a growth standpoint. Just higher inflation in and of itself can be beneficial because of the huge amount of fear of disinflation in the global system. So some of this moving away from a zero bound in US interest rates and inflationary levels can in and of itself instill more confidence to invest, which can help growth. So that's one positive. Our own view is once you get to a 2.5 or a 2.75 on a 10-year Treasury you start to lose momentum on the sell-off in bond yields. In order to take bond yields higher you're going to have to see even more confidence on the growth outlook, which means either corporate investment will have to improve further, fiscal spend will have to be realized sooner, or regulatory and tax benefits will have to be realized sooner and that's likely to take quite a long time.
We think that absolutely there is scope for further gain, but we think you've seen the majority of the primary move which in our mind means the scope for further outflows from bonds into equities, while still there, is not likely to accelerate. It's likely to moderate.
Wadhwa: One of Trump's proposed plans is a repatriation of overseas dollars being brought back onshore. What impact do you see this having on the issuance landscape with regard to US banks and corporates?
Toms: On the margin, it could decrease issuance expectations, but it's important to acknowledge that the vast majority of this cash is trapped within a few large issuers. While this is a big issue for a very small number of people, ultimately it's unlikely to be meaningfully defining in terms of corporate issuance trends. We think ultimately companies will be allowed to do with that cash what they want to with it. Repatriation of overseas dollars may moderate issuance, but really you are talking about a handful of industries or companies and not the majority. We view this as more idiosyncratic rather than structural.
Toms: Our belief is that it would be somewhat both. We are seeing signs of some increase in corporate investment, and that's good news. That leads to a higher growth environment, all else equal. If we move from a 1.5 to a 2% growth environment and a 1.5 to 2% inflation environment, that takes overall growth up to something on the order of 4% in a nominal sense. As you get nominal growth higher, that does encourage more capital spending. We do expect the upside for 2017, and one of the surprises could be stronger investment-led spending by corporations. That said, typically the best forward indicator of CapEx is revenue growth, and revenue growth is tied to GDP growth. While some of it is likely to be spent on incrementally higher corporate spending, we think the majority will be maintained in the US in cash balances and returned to shareholders.
Wadhwa: What impact do you think this will have for foreign banks' dollar funding requirements?
Toms: Ultimately our belief is that these pools of assets are deployed in dollar investments, and typically an array of high quality short-term investments, and our view is that, when repatriated, they will be in very similar instruments. The nature of the currency that has been chosen by these corporations is not likely to change. All that will change is the domicile of the account. It should not have a major impact in our opinion.
To the extent that they are spent, that could create some pressure. You have seen some pressure in short-dated corporate bond spreads already. Corporate bond spreads have done very well and you've actually seen some relative weakness in the shortest dated elements of them, which we think could be an opportunity. But ultimately, we don't think there will be a massive redefinition of the investment plans of these companies - it will just be a change in the domicile of these accounts.
Wadhwa: Many people have concerns about the decreasing ability of Wall Street trading desks to warehouse price risk in fixed income markets, and that this has been transferred to end users. How material do you perceive this risk to be and what steps are you taking to address it?
Toms: You definitely have an environment where you've taken billions of dollars out of balance sheet risk that was willing to provide a shock absorber role for the last four years. In 2008, 2011, 2015 and early 2016, you had massive volatility. It's very clear to us that the scope for dislocation in markets is higher than it used to be. It is certain that it's pushed price volatility into the bond market on the margin. That said, our view is that that volatility has already been infused and is unlikely to be infused any further. The broker-dealers have had next to zero balance sheet for years now. That's what's helped to fuel the second biggest sell-off in corporate bond history. We've seen the volatility, and we think the volatility is now known by the market. It's not new anymore. This now a regime that fixed income managers have lived under for six or seven years. That means managers are more aware of building liquidity stores and running portfolios with a plan should they have outflows.
The bigger concern for us would be legislative liquidity measures as contemplated by the SEC. We think that trying to precisely measure liquidity is a very difficult thing to do and could create a self-fulfilling lack of liquidity in certain instruments. We think the markets have adapted to this new regime. We think Wall Street has gotten more efficient at trading bonds, rather than holding them on a balance sheet, and ultimately our bigger concern would be about the SEC legislating liquidity constraints which we think would distort the markets.
Also we think that the liquidity fears in the marketplace are probably best framed around a handful of mega asset managers that need massive amounts of liquidity versus most market participants that can deal just fine in the liquidity that's available today. The mega managers are the potentially bigger concern as asset pools get too big and the lack of liquidity takes away alpha generating capacity.
Wadhwa: The sell-off in Treasuries post Trump's election win has been significant. Is this being driven by the market taking a more bullish view on economic growth or greater inflation expectations going forward?
Toms: The truth is somewhere in between. You had seen the sell-off beginning well before the announcement. It really picked up speed after the election. Treasury yields were at very low levels through the middle of the year, below 1.40 and already moving up to near 1.80 level before the election. And I think importantly you had seen inflation expectations moving higher as well. From September all the way into November, you had a meaningful move higher. To back directly into your question, we think the inflation move was already underway and that the growth outlook, that looks marginally improved in the near term, has a positive feedback loop. We would say the majority of the move is higher inflation, but that higher inflation expectation has been bolstered by the near-term outlook for growth, which we do think on the back of anticipated tax, regulatory and fiscal outlook has improved. But the majority of the change has been inflation in our opinion.
Wadhwa: Can you expand more on the challenges you see in the global economy in 2017?
Toms: We frame Brexit, Bernie Sanders and Donald Trump all as the populist movement, which is a global phenomenon. In general, there is a dissatisfaction of the electorate and the effectiveness of their governments around the world. We think that's the primary movement, and the danger in Europe is that the dissatisfaction and populist bend actually leads to more risk in the social contract through the Eurozone. In the US it leads to political volatility, but not many serious conversations about the United States splintering off. In Europe that populist bend has a much more toxic effect on the quilt of the contract across the EU. Absolutely the tail risk is that this populist bend leads to a fracture in Europe. But we think it's too early to call for that.
We'll watch the French election the most closely. We don't see other countries likely to have a motivation or a strength or big enough confidence to want to leave the Eurozone. The one that would surprise the markets most would be in France, and specifically with Le Pen, so we'll watch France most closely. We think that Italy, Netherlands and Germany are longer term stories that are unlikely to define the trading for 2017.
In Asia we are beginning to see some benefits of the weakening of the yuan and the stabilizing of Chinese growth in the 6 or 7% level. We think that's good news in the near-term, all else equal, for the Asian region.
Wadhwa: What is your view on rate hikes during 2017 and is there room for disappointment if the data comes in below expectation?
Toms: We're looking for 3 rate hikes in 2017. That's above market expectations, which are in the realm of 2. Bond markets are still hesitant to price in a third hike. They've done all they can to really price in two. The scope for disappointment is not that large yet in bond markets. Ultimately the scope for disappointment will be on the growth side. It's the classic "buy the rumor and sell the fact." Talking about regulatory benefits, tax benefits, and fiscal spending are all conversations that buoy the confidence in tomorrow's growth. The hard part is realizing that growth so I would absolutely say that achieving the built in expectations will be a bit of a feat into 2017. That said, bond markets tend to be more pessimistic and have not priced in nearly as much as we think the equities markets have.