cross asset
CIO views: adapting to a new rates regime in 2023
If 2022 was a year of regime change for investors, what comes next in 2023? A new rates reality is taking shape, with implications for everything from company earnings to debt serviceability to correlations between asset classes. Our CIOs consider the transition to higher rates as a key driver for their outlook next year.
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Fixed income: corporate-bond yields at an inflection point
The year 2022 will go down as historic for fixed income, with the largest drawdowns in over 40 years on the back of unprecedented inflation and extraordinarily hawkish central banks. As a result, yields are at decade-highs and carry is abundantly available in all currencies, even for high-quality issuers as the compensation for both interest-rate and credit-spread risks increased.
From a forward-looking perspective, we are more optimistic about the two sources of risk that apply to corporate bonds, interest-rate and credit, particularly when considered in tandem. Corporate-bond returns are a combination of these risks and have historically diversified one another, reflecting the role of central banks as a countercyclical force supporting the economy with rate cuts and quantitative easing.
However, with the reversal of this role of central banks, 2022 has been the first year in recent history in which a significant rate drawdown has coincided with a credit drawdown – an environment which we believe won’t last much longer as we don’t see such substantial increases in real rates continuing.
Optimistic outlook cushioned by carry
This forms the core of our much more optimistic outlook for 2023 for fixed income. We believe that corporate-bonds yield are at an inflection point, with spread increases likely to be countered somewhat by a drop in interest rates, making us more sanguine about duration risk. Stronger initial corporate fundamentals and the relatively robust position of banks reduces the left tail for credit risk.1 However, we envisage an increase in default rates for lower-quality issuers towards longer term averages, making active credit analysis vital.
If our conviction on yield moves does not materialise, the decade-high carry available cushions us against pessimistic scenarios in which yields increase substantially further. To contextualise the impact of heightened carry, by our calculations, the breakeven yield – or increase in yields required over the next 12 months to counteract the positive impact from carry – has doubled in high-yield markets and almost tripled in investment grade.
Yet, we don’t necessarily believe this means that yields will be falling substantially, and indeed we would expect all-in corporate yields to be more aligned with those experienced in the 2000s rather than the 2010s, a decade of yield scarcity. This is important, as, in our view, it makes fixed income not just a tactical opportunity, but structurally more appealing too, as carry should persist for years to come.
In short – the corporate bond is back.
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1.Left tail risk refers to an investment’s most extreme downside performance periods.
Asia fixed income: multi-year opportunity for spread products
Various emerging markets (EMs) are currently being hit by the dual shocks of tightening conditions through financing channels and knock-on impacts of the global growth slowdown. Faced with these headwinds, the dispersion between the stronger investment-grade (IG) countries in Asia and others such as Latin America, Africa and Eastern Europe, is increasing.
As Asia becomes increasingly domestically oriented, we are beginning to see a structural decoupling and outperformance versus other EMs. Despite immense US dollar strength, inflation pressures in Asia are well below 7% across the IG Asian countries, whereas Latin America is broadly contending with double-digit inflation. Asia’s inflation is even lower than the US and Europe’s, as it has greater self-sufficiency in food, energy and labour.
The IG economies in Asia Pacific have spent the last 10-plus years building up strong buffers and are well-positioned to bear shocks. Similarly, Asia’s growth trend is also looking brighter and diverging versus other EMs and developed markets (DMs) into 2023. India and southeast Asia stand out in terms of forward-looking growth prospects. North Asia, however, has accumulated one of the largest net international investment positions.
Credit-spread moves
Against this backdrop, Asian credit spreads have already underperformed those of DMs since 2021, owing to China’s policy shifts towards various sectors including property, its zero-Covid approach, geo-political concerns, and an unfavourable environment for asset-class flows. Asian BBB credit spreads are as much as over 300 bps wider than their US IG counterparts2. This includes large-cap technology firms and utilities in Asia.
The path of least resistance is for higher-quality Asian credit, both within IG and high yield, to experience credit-spread compression over the coming one-to-three years as US inflation continues its expected decline, China reopens its economy and growth resumes, and new USD bond-issuance trends remain negative. We expect USD-denominated issuance to be muted as domestic funding markets in large countries such as India, Thailand, the Philippines and Indonesia remain healthy, and many corporate and quasi-sovereign borrowers move part of their funding requirements from the USD market into their respective domestic markets.
We are taking a medium-to-long-term view and investing accordingly for an earnings recovery in greater China and to capture the high spread per turn of leverage in other parts of the region. As the Federal Reserve moves past its terminal rates after Q1 2023, we expect gradual dollar weakness and a much more positive environment for Asia and selected EM fixed-income and spread markets. Meanwhile, we continue to partially hedge our portfolios’ US Treasury interest-rate duration.
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2.Yields are subject to change and can vary over time. Past performance is not a reliable indicator of future results.
Equities: seek quality amid rate-hike domino effects
In 2023, we expect the global run of interest-rate hikes to end (with the exception of China, and possibly Japan), closing a tightening cycle of unprecedented speed and scale. Given the rapid pace and magnitude of these hikes, not all economic domino effects have played out but are likely to course through the most significant economies in 2023. Central banks are likely to maintain tight monetary conditions and let their balance sheets run off. Inflation should progressively recede, although elevated rates are likely to weigh on aggregate economic demand.
In such an environment, companies could still be exposed to lagging cost inflation but have a diminishing ability to pass these price increases through to consumers. In addition, for companies with material refinancing needs, the combination of high rates and wide spreads will make new funding very expensive. Although the consensus view among analysts is for 5% earnings growth among developed-market equities in 2023 – and higher still, if the expected normalisation in the energy and materials sectors is excluded – we do expect pressure on corporate margins as well as earnings.
Don’t be defensive
But investors are broadly sceptical. Global equity markets have rapidly re-rated downwards, with trailing price/earnings ratios at 17.3 times compared with the 10-year average of 20 times. There is evidence of extreme positioning, with most defensive sectors being highly valued compared to those that are more cyclical or growth-oriented. This positioning creates pockets of opportunity. As the hiking cycle ends, with interest rates resting on a higher plateau, and assuming the global economy descends for a soft landing or mild recession, we believe risk appetite would return as investors look through economic softness, seeking opportunities.
Given this context, as we approach 2023 we continue to shy from companies with refinancing needs in the next year. We are also cautious towards defensive sectors – such as consumer staples, pharmaceuticals and utilities – due to high valuations. In contrast, we favour higher quality growth and cyclical companies that have been unduly punished by the market’s morosity and are exposed to attractive long-term secular trends that should prove resilient in a recessionary environment.
The next decade’s themes are already in play
As we have articulated in our views on the next decade, four mega-shifts – the environmental transition, a return to symmetry in capitalism, the demographic deficit and emergence of a more regionalised world – should create growth opportunities different to those of the last 10 years.
As an illustration, consider US policy developments. In the last two years, the Inflation Reduction Act, the Infrastructure Investment and Job Act, and the CHIPS and Science Act together commit to more than tripling the nation’s average annual spending on climate and clean energy for this decade compared to the previous one. They will also foster job creation and re-localise some key strategic industries, like semiconductors. Seen globally, it adds to the impetus already provided by the European Union’s Green Deal.
Multi asset: a risk-based approach to optimise diversification
Niels Bohr, the Danish Nobel-prize winning physicist, allegedly said: predictions are difficult, especially about the future. As systematic investors we subscribe to this humble assessment and recognise that the present is hard enough to assess (this is the subject of a major research project this year for our team). As for the future, we prefer to prepare rather than forecast, and follow a disciplined, process-driven investment approach.
Preparing for higher rates is definitely something that occupies our minds, should this year herald a new normal for years to come. We have written extensively about the next decade and believe there is a sizeable risk that future years will be marked by higher rates, higher inflation and greater macro uncertainty.
Adapting to a changing world
Against this backdrop, how do we prepare? First, a risk-based allocation process is, in our view, a better choice than traditional allocation approaches (or the so-called 60/40 portfolio). This is because it is more adaptable to changing risk, volatility and correlation conditions. It is also more diversified, and ultimately this is our strongest conviction: diversification is the best protection against uncertainty.
Diversification across multiple asset classes remains important: in this regard, commodities have come to the fore over the past two years, but they have always been a part of our core asset allocation. Much-maligned (nominal and inflation-linked) sovereign debt belongs in our toolkit, too, because it is useful in case of a recessionary shock. Furthermore, we continuously seek to ‘diversify the diversifiers’, for instance, through convex strategies such as long-volatility trades, or trend-following strategies (which are having a stellar year after a long period of underperformance), or just the philosophical open-mindedness to embrace cash as a pretty simple shock absorber.
Ultimately, navigating treacherous markets also requires careful calibration of risk and delivering a performance path consistent with this risk profile. This year has been marked by the failure of traditional risk profiling, with conservative portfolios behaving the same way as dynamic portfolios. An explicit risk-management process, which is able to maintain realised risk in line with ex-ante assumptions, is an essential step in adapting to a changing world, in our view.
Convertible bonds: a potential surrogate to raise capital but selection is key
Inflation is proving to be high and persistent, embedding expectations that interest rates will stay higher for longer than originally expected in 2023. In fact, rates are likely to remain higher for all of next year as central banks attempt to combat sticky inflation while avoiding a policy mistake by loosening monetary conditions too soon. A significant portion of the global supply chain is still challenged by delayed reopening in China and the war in the Ukraine, neither of which will be alleviated by higher interest rates.
For much of the past decade, governments, companies and individuals have not had to face a rising-rate environment with the resulting higher cost of borrowing. There is an entire generation for whom this is unknown territory. Operating under this new regime will demand flexibility and creativity.
Convertible borrowing to preserve cash
Equity analysts have largely adjusted their earnings expectations to account for a tougher macro environment, however they may not have considered how higher rates might alter the capital structure of a firm.
The chosen source of capital depends heavily on the relative cost of debt versus equity. Convertibles could play an important role in the debt markets next year, as companies may prefer to sell their equity forward at a premium via a lower coupon instrument, helping to preserve cash. The potential upside from the performance of the underlying shares compensates investors for accepting a lower coupon than for a straight bond issue.
In our asset class, we believe the companies most at risk are those which are highly cyclical, leveraged and generate low or no cash flow. Issuers in the unfunded growth bucket are likely to underperform businesses which are adequately capitalised if we see a recession in 2023. We continue to avoid these issuers, maintaining a defensive stance in our portfolios, especially in the lower credit quality segment.
Choosing the right names
We remain confident that investment grade will fare better, generating yield and returns even in longer maturities. Higher rates could mean an uptick in defaults so active management, as well as strong issuer and sector selection, will be key. With the correlation historically high between stock volatility and a higher rates regime, the elevated levels of volatility which have prevailed in 2022 could continue. The embedded equity option in a convertible bond naturally benefits from this type of environment: we expect the asset class to continue to derive incremental value from this performance driver should rates remain higher for longer.
Alternatives: staying flexible with a barbell approach
While having had little meaningful impact on inflation so far, the Federal Reserve’s actions have started to affect the economy. Rates have moved significantly higher and equities have drifted lower. The US consumer, the key engine of the economy, is showing signs of slowing down even while remaining mostly employed.
Anecdotally, cyclical companies are starting to experience real weaknesses. Some companies have begun hiring freezes and layoffs. Still, it seems that the market has not put a very high probability on a substantial slowdown. In fact, the market remains complacent overall, believing in the soft landing and underestimating extreme scenarios, such as a recession with persistently high inflation.
Bonds do not tend to stay around the 70 to 80 cents level. It is an unstable state for them. Either the issuer addresses concerns and the bond rallies, or problems persist and the bonds go into real stress. Global markets currently give the impression that they are in an unstable state and will not stay at these levels. Volatility is elevated but not high, and spreads have widened but are not pricing in a hard landing.
Complex economic drivers
The complexity here is that key economic drivers are hard to forecast. With equities, we believe the market is not even close to pricing in the new uncertain environment of higher rates, lower liquidity and probably lower earnings. The embedded equity risk premium remains very tight and has not moved meaningfully this year. This highlights how the reduction in price/earnings ratios that we have seen in the last several quarters can be almost entirely explained by the long duration of equities. Stocks have not actually become cheaper.
To make things worse, 2023 earnings expectations have not corrected downward very much. We believe the economy is slowing and that declines in earnings estimates are likely. Key questions are whether the Fed will pivot early enough, how the Russia-Ukraine war will evolve, and whether China will act towards Taiwan and ease its Covid policy.
Alternatives strategies typically have the advantage of flexibility. The uncertainty does not mean that there are no clear opportunities. We continue to believe it is the correct environment for being flexible, while taking a barbell approach.
On the shorting side, there are still attractive opportunities to have cheap optionality through decompression trades or by being long volatility. On the long side, there are simple positions that are attractive. On the credit side, shorter duration, higher quality names are starting to exhibit attractive risk-return trade-offs.
Key trends are here to stay, such as the move towards regionalisation. Political willingness to support the energy transition will provide important tailwinds for key industries. Having the ability to be flexible means we can also invest in new markets, such as carbon. Higher carbon prices will incentivise polluters to reduce emissions, and cap-and-trade markets will structurally reduce the supply of carbon allowances.
There is uncertainty. But attractive positions exist, with catalysts for them to generate returns in 2023.
Sustainability: a new era of carbon pricing
Historically, the impacts of climate change and the climate transition on corporate earnings have been assessed in terms of the costs emanating from climate-related physical risks. This approach is outdated. As global carbon markets take shape and carbon pricing becomes more mainstream, we need a new approach to assessing portfolio risks – and opportunities – arising from the climate-transition megatrend.
In 2000, close to 0% of emissions had a cost associated with them.3 Today, 40% of emissions are covered by a carbon market or carbon tax.4 As governments move to implement their climate commitments, there is broad consensus that carbon pricing will continue to develop.
At the same time, we know that the price of carbon needs to increase significantly if current climate goals are going to be achieved. These drivers make carbon a compelling investment opportunity to achieve uncorrelated returns and a natural hedge against the risks of higher carbon prices, in addition to broader transition risks, in our view.
In addition, carbon prices have historically kept up with inflation and can be expected to continue to do so. Key compliance markets have explicit price and supply management features that support a minimal rise in prices. In California and New Zealand, for example, there is an explicit annual inflation adjustment to the auction prices.
Also, the structural features of carbon markets that reduce the supply of allowances also apply upward pressure on prices to rise over time.
Policy reforms ahead
In 2023 and beyond, we will progress through a cycle of policy reforms across several key markets including the European Union, the UK and California. All indications suggest that these reforms will result in further upward price pressures for carbon. In addition, on the heels of COP27, we expect to see continued growth in new markets and the expansion of the voluntary market as a tool for achieving our global climate commitments.
As we enter this new era of carbon pricing, investors ignore the carbon markets to their clear detriment. With regulated carbon markets having matured into a USD 900 million annual market opportunity, and voluntary carbon markets forecasted to grow from USD 2 billion to USD 50 bn by 20305, the global carbon markets have the potential to both mitigate climate-transition and inflation risks while benefiting from attractive returns with a low correlation to traditional asset classes.
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important information.
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