CIO views: finding silver linings in bearish markets

Asia fixed income: decade-high yields after an unprecedented sell-off

This year has marked an unprecedented sell-off in global fixed-income markets, with anything from US Treasuries to emerging market (EM) credit down by double digits. Amid stubbornly high inflation and potentially slower growth dynamics, major central banks are hiking rates more aggressively.

We believe inflation is peaking and will moderate over the coming quarters. In this context, we believe US Treasury yields have overshot their long-term fair value in light of slowing growth and moderating inflation over the medium to long term. We see attractive entry points for investors here.

Within credit, Asian spreads have widened across investment grade (IG) and better quality high yield (HY). We see a strong opportunity set within Asian and EM high-grade IG credit, with yields in the 5% to 7% range (in USD-denominated debt) for mid-duration portfolios of 6 to 7 years¹. This average duration is still lower than US credit and developed-market IG credit.

Asian IG is well positioned to capture the market recovery as US Treasury yields are peaking, in our view, and following a period of higher spread volatility and widening. A significant number of BBB-rated corporate spreads are wider by 50% to 100% over the past two quarters. A moderating growth environment over the next two-to-five years and the start of a strong disinflation trend will likely give investors strong returns from higher quality, diversified, longer duration IG portfolios, in our view.

Within HY, large-cap opportunities in crossover and BB-rated issuers are now trading at yields in the high-single-digit range¹. Asia and EM have already suffered an unprecedented default cycle from Russia’s index fall-out and China’s HY distress, and this extreme left-tail outcome is behind us given this stage of the default cycle. Still, in recent weeks, HY globally has moved to price-in fear: as this normalises and markets stabilise into 2023 with a Federal Reserve rate cut expected then, this segment could generate equity-like double-digit returns for HY.

 

Summer rethink

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Equities: for growth opportunities, be selective and look to China

The risk of recession is usually a headwind for growth stocks. As economic activity slows and sentiment darkens, low-beta and quality stocks tend to outperform².

For growth stocks to become resurgent, the following conditions are usually required:

• Ongoing deterioration in economic activity – with signs the downturn is bottoming out
• Shifting central-bank policy, from tightening to accommodation
• Significant, downward earnings revisions by analysts

None of this is happening yet – especially in developed markets. Not long after ruling out a 75 bps interest-rate increase, the Federal Reserve (Fed) hiked by exactly that amount. The spread on the 10-2-year US Treasury yield curve is close to inverting, indicating that markets haven’t reached consensus that a recession is imminent. Meanwhile, the spread on the 10-year-3-month curve – the Fed’s preferred gauge of investor confidence – remains elevated. US ISM surveys continue to indicate expansion and the labour market is still hot.

Should investors give up on growth, for now? No, we see two reasons to look for opportunities:

1. Favourable conditions for growth stocks are visible in China: economic activity is weak – especially in comparison with the US (see figure 1) – and central-bank policy is more accommodative. Earnings expectations for growth companies have been revised lower by -24% on a 12-month rolling basis, relative to +10% for value names. An easing of zero-Covid restrictions would provide further support, in our view.
2. Irrespective of country or region, we believe it’s important to anchor equity portfolios in companies with quality fundamentals. Among growth names, this means focusing on businesses that can self-fund their expansion over a three-to-five-year cycle. Valuations for these firms have been more resilient, in contrast to growth companies relying heavily on external funding.  

 

Figure 1. Leading economic indicators: US and China

Source: LOIM analysis, Bloomberg as at June 2022.

 

Summer rethink

Interacting with nature is increasingly recognised as being important for mental wellbeing (such as stress relief), physical health (including fitness and weight control), as well as being fundamental to eco-tourism and encouraging more local tourism.

Reconnecting with nature is the topic of Richard Louv’s book, “The Last Child in the Woods.” The author documents how children are becoming less exposed to the outdoors, leading to a so-called “nature-deficit disorder” that ultimately harms society and individuals. Enjoy reading it under a tree, in the restorative shade of nature.

 

Source

(2) Based on LOIM’s analysis of developed-market equity returns.

Convertible bonds: dislocations after indiscriminate sell-off create openings

The sharp and prolonged sell-off in global equity and credit markets in 2022 has reduced the equity sensitivity of a large part of the convertible bond universe. This has created a rare investment opportunity for fixed-income investors seeking a fixed rate of return.

Historically, equity exposure has been an important performance driver for the asset class, but if equities disappoint, credit can still offer strong return potential. In our view, this is an environment where credit can produce equity-type returns.

Many convertible bonds from solid borrowers are currently trading at their bond floor (or minimum theoretical value) due to the equity sell-off. This means convertibles are functioning as a traditional fixed-income instrument yet can still offer upside potential via the embedded equity option.

Current market timing appears propitious due to the technical configuration of the convertible asset class: a significant part of the universe is dislocated and overlooked after an indiscriminate sell-off that did not take into account companies’ profitability or need to refinance.

There are plenty of other silver linings for the asset class:

• It is typically less exposed to inflation and interest rates than traditional bond instruments
• Convertibles usually have a shorter maturity than the average standard corporate credit
• A surge in global M&A this year, or issuer buy-backs, would also prove supportive

 

If 75bps is to be the new 25bps through the summer months and terminal rates are revised up in both the US and Eurozone, we firmly believe the time is right to revisit a global convertible bond buy-to-hold strategy.

Want to read more? Explore our feature viewpoint.

 

Summer rethink

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Alternatives: risk-premium adjustment and massive rotations spur opportunities

Currently there are multiple risks looming over the performance of a diversified portfolio. These include spiralling inflation, interest-rate hikes pushing the economy into a recession and escalating conflict between the Eastern and Western world. This is creating an adjustment in risk premium and spurring massive rotations across sectors, style and regions.

Such an environment can create attractive opportunities in volatility relative value, global macro, commodity trading advisors (CTAs) and tail strategies. Volatility relative value can benefit from increasing flows in the derivatives market, which are creating dislocations and arbitrage opportunities. Global macro and CTAs can capture up and down trends in equities, bonds, foreign exchange and commodities. These strategies have performed extremely well this year³. Tail strategies are approaching levels where another market leg down could benefit them, in our opinion.

So far, the risk-premium correction seems relatively healthy and the market has not showed signs of panic. If this happens, there could be a strong buying opportunity for event-driven strategies, which will be able to deploy capital into distressed debt that can trade at as low as a 30%-40% discount to par and pay double-digit coupons. Distressed equities trading on low multiples (despite running healthy businesses), or merger arbitrage spreads could also become attractive.

Another interesting opportunity is the potential great rotation from growth to value. Value has underperformed growth for years in a low-yield environment. With inflation and recession risks looming, value stocks can be in the inner of an outperformance trend. Here again, event-driven or equity long/short strategies with a value bias can outperform, while limiting investors’ market beta exposure.

 

Summer rethink

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Source

(3): Past performance is not an indicator of future results.