'We’re on the classic roadmap for heading into a recession'

Industry veteran Barry Allan says widening credit spreads, not rising interest rates, mean fixed income is about to get even worse

'We’re on the classic roadmap for heading into a recession'

Inflation has changed what banks can do to curb inflation, but also how advisors should look at fixed income products, particularly now with credit spreads increasing, said one CEO who’s doing that.

“I think what we have today is essentially the polar opposite of what we’ve had for the last 20 years,” Barry Allan, President, CEO, and Chief Investment Officer of DMAT Capital Inc. told Wealth Professional.

Over time, the central banks would flood the system with liquidity, so inflation didn’t climb above 2% for any period. But, the pandemic has disrupted the supply chain, caused labour issues, and increased many people’s savings, causing a massive capital underinvestment in energy just as we’re starting to fight climate change and seeing a massive commodity disruption, especially with the war.

“What equity investors did is buy every dip and what fixed income investors did was take as much credit risk as possible because, if there was a recession coming, it was going to be very very short-lived because the central banks would flood the system with liquidity again,” said Allan, noting that they can’t do that now, because inflation has increased so dramatically.

“All the largest fixed income ETF managers are doing what they’re been doing for the last 20 years, which worked: that was take as much credit risk as possible,” he said, noting their multibillion dollar funds now are full of illiquid credit products just as credit spreads have widened. “In my opinion, they’re about to widen dramatically more, and I think that’s the next shoe to fall: the credit shock.”

Allan is watching oil prices, but also expecting a huge rally in government bonds, so he’s concerned about heading into a deep recession.  

“We’re on the classic roadmap for heading for recession. We’ve got the Fed hiking rates aggressive. We’ve got the U.S .dollar at a decade high. We’ve got an oil shock, where oil has tripled or more. We’ve got a housing bubble, and we’ve got inflation at 8.6%,” he said. “We’ve had the worst four months in history for fixed income, and I think it’s going to get worse. But, it’s not going to be because of rising interest rates. It’s going to be because of widening credit spreads.

“We’re not going to get out of this situation in five or six months. We’re going to have multiple years before inflation materially declines. The only way we’re going to get out of this quickly is if the Fed lowers rates to zero and starts quantitative easing again, and they’re doing the opposite.”

Allan is recommending that advisors stay away from credit risks.

“80% is exposed to investment grade or high-yield credit, or emerging markets credit, or mortgage-backed securities, or some kind of credit spread, and that’s the problem. We’re all locked into these markets that have become terribly illiquid in the last four months, so they can’t get out even if they want to,” he said.

His solution is to stay in short duration government bonds with some exposure to energy, or even just buy oil. He’s been doing that with the Horizons Tactical Absolute Return Bond (HARB) ETF that he manages, which seeks absolute returns with low volatility in any market environment. Launched in December 2019, it now has $75 million in assets. It’s outperformed other Canadian fixed income funds by more than 7% in the past year. It is down year-to-date about 1% while other funds are down at least 6% to 8%. On March 31, HARB was up 5% while others were still at minus 2%.

“Our goal is to provide risk adjustment returns and produce positive returns,” said, “and our fund is negatively correlated to stocks when they go down., which I think is extremely important.

“So, I think the message here is: there are ways to produce positive returns in fixed income in a rising interest rate environment. I think we’ve proven that.”