CIO views: positioned for a credit crunch?

Asian fixed income: quality duration to benefit from easier domestic policy, looser credit

The US monetary tightening of 500 bps in just over 12 months is very analogous to monetary policy typically characterising emerging markets. It is therefore no surprise that the US economy is expected to slow considerably, something that the Federal Reserve requires to achieve its inflation target. However, at a 5% federal funds rate, we believe that various parts of the US banking system will simply not be viable given that the US is a 2% trend growth economy and the US Treasury curve is already heavily inverted.

In comparison, Asian central banks have not needed to tighten monetary conditions as much, with Indian and Indonesian base rates at 6.5% and 5.75% respectively. We believe all Asian central banks have completed their rate hiking cycles and will lead rate cuts globally in 2024. We expect Indonesia to start the trend, dropping rates from 5.75% currently to 5.25% by end-2023.

Asian growth is expected to rebound this year, unlike that of developed markets. Various Asian companies now have the benefit of shifting some or all of their USD-based funding to domestic markets, given easier credit conditions at home. This is in contrast to the US, where lending from regional banks is expected to slow, providing the equivalent of 50 bps worth of Fed rate hikes.

We now expect to enter the final phase of US monetary tightening, during which the Fed rate of 5% is held for an extended period and then cut towards 3%. In this environment, we anticipate the dollar will lose strength versus Asian currencies and the Treasury curve will further bull steepen into 2024. As such, we are currently highly positive on high-quality, Asian investment grade debt with a longer duration bias. Our stance is progressively positive on selected high-yield names with a domestic Asian bias, as we expect 2024 to be a year of synchronised global rate cuts.

Equities: survival of the biggest?

Will the US or Europe enter recession in the coming months? To mitigate this key risk, global equity investors appear to be allocating to stronger, more diversified and free-cash-flow-generating mega-caps.

The steepest and most severe US tightening cycle in more than three decades is continuing to filter through the economy, causing collateral damage among US regional banks and spurring a flight of bank deposits to money-market funds. In this context, the Capitol Hill drama about lifting the US government’s debt ceiling to prevent a sovereign default is unhelpful.

March of the mega

So far, equity markets have compartmentalised areas of weakness – from regional banks and commercial real estate to industrial equipment and consumer cyclicals. This helped major developed-market indices return between 6% and 15% by the end of April.² Such performance has also been driven by mega-cap stocks with market capitalisations exceeding USD 500 billion: with a weight of 15% in the world market, they have risen 30% to contribute 40% to the global index’s rise.³

These mega-caps are the logical winners amid current jitters. They are regionally diversified, generate free cash flow and are not reliant on debt funding to maintain or expand their growth. But they are not the only companies withstanding the pressure: numerous Q1 earnings reports by non-mega-cap firms across sectors have been positive, contrasting with lowered expectations, bringing some relief across the market-capitalisation spectrum.

Secular vs cyclical

As the effects of monetary tightening and restricted bank funding continue to unfold, we remain focused on the fundamental quality of companies and look for pockets of growth that are not driven by the economic cycle. Across markets and on a much longer time horizon, the transition to a Circular, Lean, Inclusive and Clean – or CLIC® – economy through 3+1 systems changes is the most attractive secular growth story, in our view.

Sources.

2. MSCI World, MSCI Europe and MSCI Japan indices. Source: Bloomberg at 01 May 2023.
3. Source: LOIM analysis on MSCI World data from Bloomberg at May 2023.

Convertible bonds: offering convex exposure with a bias to quality

Many traditional investment strategies suffered significant drawdowns in 2022, anticipating the effect on the world economy of high inflation and increasing interest rates. So far, 2023 has perhaps surprised the majority of investors with gains for both global equities and credit. Notwithstanding, market opinion remains divided as to whether the macro environment could worsen. Additionally, the instability we are seeing in the US regional banks seems to be precipitating tighter lending conditions, adding uncertainty to general financial conditions.

In this context, it is advantageous to hold strategies that allow investors to be simultaneously invested in the equity and credit markets through convex structures that can protect in a downside scenario.⁴ Convertible bonds are one of the most asymmetric long-only strategies.

Today, the asset class offers inexpensive optionality due to attractive valuation levels, a significant yield pick-up⁵ compared to historical levels (investors are paid through positive yield to hold convertibles), and exposure to quality growth companies that we believe should perform well when the rates backdrop becomes more benign.

Furthermore, convertible bonds also offer balanced exposure to global equity markets and to primary issuance, which has been accelerating in recent weeks. We believe that owning a convertible strategy, with a bias to quality from both from the equity and credit perspective, could prove a potentially profitable way to navigate this uncertain market.

Sources.

4.Capital protection is an investment goal that cannot be guaranteed.
5.Yields are subject to change and can vary over time.

Multi asset: assessing the signals in a challenging environment 

“The future ain’t what it used to be”, US baseball great Yogi Berra said. Or is it?

As systematic investors, we avoid taking big and bold bets, being more concerned about covering all bases than betting on the one correct scenario. Thus, we prefer to be prepared, and to follow a disciplined, process-driven and risk-based investment approach.

Today, as the transmission of monetary policy (through tighter lending conditions) looks set to accelerate, recession fears are spurring some investors to de-risk portfolios and retreat to the perceived safety of government bonds. Our process integrates a number of signals, which are interesting to review:

• Yes, bond valuations are undoubtedly more attractive than, say, a year ago, although yield curves are inverted, which nullifies one of the traditional positives of bond investing – the passage of time (aka, rolling down the curve)
• Bond volatility remains at extreme levels, reflecting a high degree of uncertainty about macro drivers, namely growth and inflation prospects
• Finally, price dynamics are mixed (more positive in the US and negative in Europe), while short- term yields remain elevated and therefore attractive
   

Thus, while bonds belong in our investment universe as they always do (and should prove useful in case a recession does indeed emerge), they are not a glaring buy at this point, in our view. Other asset classes display more promising signals. Volatility for credit and equities has abated over the last few months – it’s not yet back to normal, but on the way there. Price dynamics are more positive, too, as sentiment currently matters probably as much as the macro picture. We believe they merit continued investment, close to average allocations. Finally, risk management remains essential.

As the environment remains challenging, we retain a prudent positioning, falling back to that simple shock absorber, cash (overweight versus the historical norm) – fine-tuning our risk deployment and remaining in line with, but not over, our portfolios’ (and our clients’) risk profiles.

Sustainability: is tighter credit a headwind or tailwind for climate-focused private debt?

High interest rates, regulatory support for decarbonisation and tighter financing markets are creating an attractive panorama for private debt focused on climate solutions.

With interest rates at a 15-year peak after the steepest tightening cycle in 35 years, US regional bank failures and market dislocations are exacerbating the retrenchment of traditional middle-market sources of credit to growth-focused private companies in sectors like distributed renewables and energy storage.

For example, venture-capital financing for climate-tech projects declined 35% in deal value during Q1 compared to Q1 2022. This is indicative of the financing pullbacks inhibiting companies’ ability to fully capitalise on landmark policy initiatives such as the Inflation Reduction Act. As a result, the migration towards private lenders able to draw upon committed, patient capital is accelerating.

Private credit and net zero

Private credit today represents a USD 1.25 trillion market – more than five times its size in 2008. It offers significant advantages to borrowers, including flexible loan structures and certainty over deal execution and confidentiality, which is particularly attractive in this volatile environment.

As a source of patient capital, the market plays an important role in mobilising investment in companies across net-zero-oriented industries aiming to scale-up their goods or services to meet the escalating demand for climate solutions. 

This underpins a clear opportunity set: increasing demand from unlisted companies that are not private-equity sponsored and typically operate in high-growth but inefficiently financed industries, and which are playing key roles in decarbonising the economy.

Secure, engaged lending

Loan facilities structured for these companies tend to be bilaterally negotiated, enabling private lenders to establish robust covenants and security packages, and exercise greater control in underwriting due diligence, documentation and compliance monitoring.

These direct transactions allow lenders to connect strongly with borrowers’ management teams and deeply understand the drivers of the business. This supports engagement and stewardship, which help produce the qualitative and quantitative information critical in demonstrating measurable environmental and social impact alongside compelling financial returns.

Alternatives: increased differentiation can bring opportunity 

One of the more direct consequences of the banking crisis is the reduction in available credit, as banks grow more cautious with lending because of balance-sheet risk. This is especially true for regional banks, which are the biggest loan providers of the US economy. The combined effect of stresses in the banking sector and the aggressive Federal Reserve hiking cycle suggests to us that inflation has most likely peaked, although it remains far above the Fed’s target.

Forward-looking indicators – such as Manufacturing PMI, University of Michigan Consumer Confidence and the Philadelphia Fed Business Outlook – remain depressed and point to a slowing economy. The consensus among economists is that growth is indeed slowing and starting to reflect the Fed’s tighter policy and the removal of fiscal support. The US consumer is cutting back as well. Risk premiums and volatility, however, remain low at this stage.

When markets are more difficult, and when the cost and availability of capital become more discriminating, companies become differentiated much more quickly. This is typically a good thing for hedge funds. Our overall focus within 1798 is on relative-value strategies, and most of these tend to do well in times of differentiation, dispersion and mispricings.

Periods of increased stress can therefore provide many opportunities. Funds like those in our credit convexity strategies and in our volatility strategies usually benefit directly from credit decompression or dispersion. As such, many of our funds have recently been increasing their exposures.