During the week prior to PWM’s interview with David Zahn, Franklin Templeton’s head of European fixed income, at least three key events influenced his thinking.
US forces assassinated Iranian general Qassem Suleimani; an overwhelming majority of UK MPs carried the third reading of prime minister Boris Johnson’s Brexit deal through parliament; and German chancellor Angela Merkel, under huge pressure to raise government spending at home, visited Moscow for talks with Vladimir Putin about regional conflicts involving Russia.
A forthcoming transfer of power in Germany might lead to a dangerous political vacuum of particular concerns for financial markets. “If and when Merkel retires, Europe will no longer have a strong leader to bring the continent together in the event of a crisis,” says Mr Zahn, who oversees the €3bn ($3.3bn) European portion of Franklin Templeton Fixed Income's $155bn bond portfolio.
“I always thought economics would take more of a back seat, with politicians coming to the forefront,” says the veteran bondsman with more than 25 years of fixed income trading experience.
The most important trend shaping markets today is the increasing divide between the “haves and have nots”, which delivered Brexit in the UK and proved the main impetus behind the election of both Boris Johnson and Donald Trump, he says.
This political polarisation “creates market and economic undercurrents and it is very important to understand how they work,” says Mr Zahn, suggesting investment managers must study the “political gamesmanship” leading to both trade wars and physical conflicts. “But I never thought things would come this far, when politicians are driving everything.”
Seven years ago, anticipating these trends, Mr Zahn completed an MA in War and the Modern World at the University of London’s King’s College. As well as ongoing concerns about Middle Eastern stability and “unknowns” about the European project, he was keen to study the effects of increased tension and trade competition between the US and China.
“How does an existing superpower deal with a new superpower? The last time we saw this was in a battle between the US and UK,” comments Mr Zahn.
Eye on the headlines
The key stories he is currently tracking include the US presidential election, Brexit and the views of new bosses at both the European Central Bank and the Bank of England’s Monetary Policy Committee.
“The presidential election is the biggest factor. Its impact on European markets can vary quite substantially, depending on how it goes,” he says, with bond markets beginning to take notice once a Democrat candidate has been nominated and spending and healthcare plans nailed down.
This constantly shifting political backdrop ensures there are always opportunities for the “optimistic bond manager” to make money, compared to his colleagues in equities, which “in general only do well when the economy is doing well”.
This fundamental change in factors determining bond market trajectories means fixed income specialists have had to vastly improve their analysis of society and human behaviour, rather than relying on quantitative skills.
“Bond managers have become much more adept at dealing with the people side,” he says, especially when it comes to following corporate bonds.
Embracing ESG
Perhaps the embodiment of this signature move, away from a detached position to greater engagement with society, lies in fixed income’s embrace of environmental, social and governance (ESG) investment criteria.
“Fixed income investors care more and more about ESG risks in their portfolios,” says Mr Zahn. This includes ensuring they are being adequately rewarded for managing assets. “Not only do we want to create a better world, but we are also increasingly recognising environmental and social risks which impact governments and corporates. In the past, only equity managers focused on this, but now it is becoming more commonplace in fixed income.”
This skill, he believes, will, more than anything, define successful fixed income managers of the future. “In five years’ time, if you’ve not integrated ESG within your fixed income investment process, you will struggle,” says Mr Zahn, convinced both by the strong showing of green political parties in elections across Europe and the increased “green taxonomy” adopted by multinational institutions including the EU.
Private banks, and their use of the United Nations’ Sustainable Development Goals to help define clients’ objectives – with the help of fixed income allocations – can play a particularly important role in this changing model.
“Carbon emissions are the best to focus on, they are easier to measure and people care very strongly about them,” he says.
Despite these challenges from both politics and the climate, Mr Zahn believes the role of fixed income in investors’ portfolios has not changed radically during his tenure, offering liquidity and a “ballast” against riskier assets. And these tenets do not just apply to institutions, often required to hold bonds to maturity in order to meet liabilities.
“Even high net worth investors need a part of their portfolio, which is liquid, to provide some insurance at a lower risk,” he says. “For most of last year, every risk asset went up, so people were asking ‘why do we need bonds?’ But in the fourth quarter, having bonds was something they were quite happy with. They may have gone down a bit, but not as much as riskier assets.”
Private banks across Europe are looking for “best in class, top-quartile products”, but more importantly, they want to see more diversified funds, where the asset manager rather than the bank is responsible for allocation.
“They want you to move the money around for them,” stresses Mr Zahn. “Most of them can’t move it as quickly as they would like to. Wealth managers are becoming more sophisticated. They want regular access to portfolio managers to discuss their views.”
Franklin Templeton’s acquisition of its US competitor Legg Mason to create a $1.5tn asset management house will add further firepower to the armoury.
Despite much lower yields today than in the 1990s, when he cut his teeth in the bond markets, and lower liquidity in some areas, Mr Zahn sees much greater opportunities today.
“When the euro started trading in 1999, the corporate bond market was almost nothing. Now it is worth €2tn ($2.2tn) and is globally diversified,” he says. “We have also seen markets innovate and will continue to do so, especially in private credit and other areas which offer opportunity. People always ask me if it’s a good time to buy fixed income. I tell them it’s always a good time to buy a certain kind of fixed income. That’s why asset allocation is so fascinating.”
Currently, his portfolios include Italian and Spanish paper as well as long-dated German bonds, also embracing local currency instruments in Hungary and the Czech Republic. On the investment grade side, he favours UK opportunities ahead of Europe.
Panic stations
But there is still a slight edginess to Mr Zahn, as he plots his portfolio strategies in Franklin Templeton’s offices perched above London’s Cannon Street station.
In order for bond aficionados like him to really relax, we need a market crisis, something Mr Zahn has experienced perhaps “three or four times in my career”, triggering familiar buying reflexes.
“When there is panic in the market, there are great trades to be done. You can feel the fundamentals are there, but everyone is moving in one direction.”
He recalls experiencing “the feeling” during the 1998 Russian crisis, the 2008 Global Financial Crisis and the Italian sell-off of 2011. “Italian bonds were trading at 7 per cent, without any risk and no chance of Italy leaving Europe. It was obvious that you had to buy these. When everyone is selling and panicking, you can very selectively pick things up.”
It’s when Mr Zahn is smiling, that the rest of us should be getting worried.
