Quarterly Equities and Multi Asset Outlook - Q2 2023

The following day, everything changed.

Markets are now priced for the next move in US interest rates to be down.

The collapse of Silicon Valley Bank (SVB) and the ensuing exploration of contagion fears has overwhelmed any indicators from the real economy that the Fed might still have some work to do. Indeed, the effective tightening in liquidity provision likely to be offered by a newly-cautious banking sector is now perceived as doing the heavy lifting from here, with short-run macro data seen as categorically backward-looking and less relevant.

As asset allocators, we are used to the market’s occasional reminder that it is more than ready to teach humility to any over-confident, prediction-laden investors. So it is with a healthy lack of certainty that we confront the range of plausible routes down which the global economy and markets may now travel. Observing market price behaviour is a key starting point.

In the context of such a sharp reappraisal of the policy-rate path, it is interesting to note that the overall equity market continues to be relatively well behaved (substantially supported in the US by large cap tech which may be perceived as being somewhat ahead of the game). Furthermore, an almost too-composed response to events by financial markets at large is illustrated by our investor ‘narrative monitor’, which is showing no meaningful change in the level of stated concerns about recession (or inflation) in market news media, despite what can reasonably be considered a meaningful upset.

As we have seen in the past few weeks, with the European Central Bank (ECB) hiking 50 bps and the Fed hiking 25 bps, central banks remain primarily focused on inflation-fighting. In this regard, it will be important to assess signals from the credit channel that the banking crisis may indeed be ‘helping’.

The strong move in bonds, with long-term treasuries rallying from 4.0% to about 3.6%, delivering a capital gain of more than 5.0% over a matter of days, has led us to tactically scale-back our duration exposure, taking profit from such an outsized price move.

More strategically, we continue to see enhanced return and diversification opportunities across the fixed income space – as demonstrated by the renewed decorrelation seen across asset classes in recent weeks. We maintain a preference for the long end of the Treasuries curve (though much reduced from the fourth quarter of 2022) and we also like selected emerging market sovereigns and currencies, such as Brazil and Mexico. Within credit, we have been taking advantage of some interesting opportunities in terms of both spread and outright duration exposure in areas of European Investment Grade credit across our Sustainable and Income strategies. For our broader Multi Asset range, we maintain a relatively neutral stance on credit overall. Elsewhere, our equity exposure is neutral to underweight, and we have a relative preference for non-US markets. Having responded to market volatility in the fourth quarter, we have generally been moving to more neutral positions in our strategies, with scope to add risk should ‘episodes’ of volatility present opportunities. 

Take for example SVB. By early February, it was one of the best performing bank shares of 2023. By mid-March, the shares had been suspended (having fallen 70% from the highs) and the company taken over by regulators.

Whilst we’re not necessarily suggesting there will be ‘another SVB’, the rest of the year will likely be equally challenging.

There are difficult central bank policy dilemmas ahead. The hard versus soft landing debate still rumbles on. And we’re rapidly approaching quarterly earnings season – which will not only inform as to the shape of the downturn and potential recovery, but also provide more data on how the banking sector is coping with the SVB fall out.

What can investors’ do in these uncertain times?

We have favoured a balanced approach.

We’ve been adding risk where opportunities arise. Scaling back when the fundamentals have clearly changed. And ‘biding our time’ in instances where we don’t have a particularly strong view or where the risk-reward is unclear.

Besides raising cash in a number of strategies in anticipation of opportunities ahead, where opportunities have presented themselves recently, we’ve used the market volatility to add to existing holdings at more attractive prices, and find good entry points for new positions – particularly within healthcare and utilities. Elsewhere, we’ve been rotating our exposure among IT names. We’ve also not been afraid to cut our losses when warranted. Some of the US regional banks are an example of the latter. Even though shares across the sector have fallen dramatically, the likely cost of increased regulation and oversight will mean structurally lower profitability and returns.

But we also remain nimble.

Even as long-term investors it’s important not to become entrenched or dogmatic with one’s views or positions. This is particularly the case in rapidly-changing financial markets.

Facts can change. Share prices and valuations can change even faster.

Be mindful of the challenges ahead. But be prepared to capitalise on the opportunities that these will inevitably create.

Looking forward, numerous questions arise from the recent turmoil: is the financial system sound? What is the right cost of equity for a bank? What will be the impact on the real economy if credit conditions tighten? Have interest rates peaked? Will sector/style leadership change?

All these questions have potentially profound implications for markets. Perhaps the simplest way to position a portfolio is to focus on fundamentals and ensure valuations are underpinned by robust balance sheets, good yield support and dividend cover. Following the recent sell off, the FTSE All Share Index is well capitalised, with a net debt-to-EBITDA* ratio of just 1.3x, and now trades on a 12-month forward price-to-earnings (P/E) ratio of 10.1x. Meanwhile, the 12-month forward dividend yield is 4.5%, implying dividends are more than twice covered by prospective earnings⁴.

²  Source: Datastream, FTSE All Share total return in GBP as at 8 March 2023 and 31 March 2023.

³  Source: Datastream, FTSE All Share total return in GBP as at 27 March 2023. Rebased to 100 as at 01 January 2023.

⁴  Source: Factset 28 March 2023.

* EBITDA = Earnings before interest, taxes, depreciation and amortisation.

Maintaining a diverse range of holdings will also be important. Confidence has rapidly collapsed and, whilst it is tempting to solely hide in defensive names, a trigger for confidence to reassert itself could emerge and quickly result in a rotation back to more cyclical sectors.

From a bottom-up perspective, the questions around market leadership are particularly relevant. If interest rates have peaked and market leadership moves away from ‘value’ sectors, which other areas of the market could come to the fore? Obvious immediate beneficiaries would be consumer staples and pharmaceuticals with their ‘long duration’, defensive earnings. However, we also believe it is worth looking at other underperforming sectors, which may also benefit from a revised outlook for interest rates, even if their earnings remain somewhat cyclical. This would include the UK housing stocks – which now trade at around book value, with clear signs of incrementally improved trading – and UK real estate (which includes REITs) – trading on a 26% discount to forward net asset value (NAV)⁵, even though much of the adjustment to cap rates may have already taken place.

In summary, the events of March have reminded us how quickly markets can change when unexpected things happen. Hence, in looking ahead to the second quarter, all we can really say with any confidence is that we expect markets to remain volatile, and we remain alert to exploit potential value opportunities when they occur.

⁵ Source: Panmure Gordon research, 27 March 2023.

Finally, some pay increases

Japan’s unions recently secured significant increases in this year’s shunto pay-bargaining round; the mean increase appears to be in the region of 4%, above market expectations. Labour shortages are driving up wages in many sectors of the economy across skilled, unskilled, part- and full-time workers alike. The unemployment rate looks set to return towards levels last seen in the early 1990s (ca. 2%), while new job openings continue to climb back toward pre-COVID highs. Ongoing wage rises of 3-5% in the coming few years seem increasingly likely. Compared to cash earnings growth in the prior two decades of almost zero, this represents a significant change. Two key questions leap out; will this lead to higher consumption, and will corporate profit margins suffer?

On the consumption front, whilst the 4% wage round is roughly equal to current headline rate inflation, easing energy prices and a slightly stronger yen suggest the Consumer Price index (CPI) trends towards 2% over the balance of 2023. Combined with ongoing re-opening normalisation, it is easy to imagine this helpful rise in real incomes drives domestic demand growth above current expectations.

In terms of profit margins, other things equal, higher wages should squeeze margins. However, this assumes productivity doesn’t change when, in fact, we see significant ongoing gains in corporate productivity, certainly in the listed corporate sector. Moreover, it assumes that product prices are not being increased to offset rising input costs, which is also happening.

In general, while economies elsewhere are trying to contain wage-price spiral dynamics, Japan is encouraging them. Higher real wages, higher productivity, higher real growth, modestly positive inflation and higher nominal growth can easily take place with flat if not rising margins.

A positive feedback loop between prices and wages is entirely plausible in Japan, which would add a meaningful potential tailwind to what we believe is already a compelling outlook for stockmarket profits growth.

For example, we added to our core China holdings early in the fourth quarter of 2022, when sentiment was especially poor around all things China. More recently, we have reduced exposure to perceived China re-opening ‘winners’, which had rallied aggressively, and allocated resources to long-term structural growth areas that fell out of favour, like certain renewable energy companies. Potential future opportunities include regional financials, should they get caught up in further global contagion fears, with a number of banks we hold being better capitalised and running more conservative balance sheets than their global peers. In addition, these banks also run much more ‘plain vanilla’ banking operations. There are also a number of cyclical companies that we follow, which could be temporarily vulnerable to global growth fears. While we are not in a position to forecast global demand any better than the market, we do have the ability to identify industries where supply conditions are very tight compared to historical standards.

In summary, we are continually striving to position our research effort and portfolio construction in a manner that allows us to take advantage of market disruption rather than having to forcibly react to it.

Across EM banks, Available For Sale (AFS) assets are marked to market and gains/losses taken to capital. EM financials have also not been exposed to the long bond market rally ahead of the recent tightening in US dollar rates – local EMs have never cut rates to the same extent. There is much lower risk of skeletons in the closet. Within insurance, in the chase for yield, western companies have added many more BBB-rated corporate bonds which are vulnerable to downturn in a recession scenario, not to mention more vulnerable to rising rates or a buyer’s strike. Again, EM insurers have not engaged in the same activity. For these reasons, we maintain an overweight in financials across EM and do not see the channels of contagion from recent events.

Where EM financials could be impacted is via the risk of a protracted slowdown/hard landing scenario in the US and Europe which would slow growth in EM, and inevitably pose the normal risk for banks of asset quality issues being higher than expected. A risk we are mindful of and monitoring. That said, we think there is decent margin of safety in the sector overall as it trades at a significant discount to other sectors within EM, for potentially higher returns. Knowing our holdings intimately and being prepared to evaluate new opportunities using our well-defined process have allowed us to navigate this bout of pain successfully and sow new ideas.

The Fed reaction here could act as a catalyst for EM markets to find more solid footing. If the Fed pauses rate hikes, that would give EM central banks breathing space to cut rates from elevated levels. Once the current risk-aversion episode ebbs, the US dollar may weaken, which would also provide a favourable backdrop for EM equities.

The bottom line, we continue to see positive catalysts for EM given the starting point of attractive valuations and improving margin scenario for corporates. China re-opening helps underpin that confidence, even though long-term challenges faced by investors in China persist.

This further fuelled the politically loaded ‘in favour of versus against ESG’ discussion in the US, and even led a prominent governor to blame the failure directly on the bank’s Diversity & Inclusion initiatives. The company did have good social policies in place, matching their California-dominated stakeholder base, but we believe that most would agree that the causality argument is flimsy.

We are all busy thinking about where the next crack might appear, and what the ripple effects might be, but situations like this highlight the importance of the (sometimes less obvious) responsibilities of a portfolio manager. Not predictions, but portfolio risk management skills and single-company due diligence rigour. Both are especially important at times of elevated liquidity risk – and liquidity risk is clearly elevated as the era of easy money comes to an end.

Resilience of business models and robustness of balance sheets will be key requirements if liquidity becomes harder to access. In our strategies, we perform vital assessments of companies’ quality, staying power, financial strength and general ability to deal with external shocks. Our Impact strategies are mandated to also invest in younger, pioneering companies with strong growth potential. This makes the resilience assessment even more vital, because small and growing companies are more vulnerable if access to capital becomes scarce and more expensive. However, these companies form only a small part of each strategy, and they typically have a flexible cost base, low capital requirements and strong balance sheets. The risk from these companies is also balanced with those generating plenty of cash and good, steady returns. We have not identified the need to make any material strategy changes in preparation of potential future cracks. At the margin, we have trimmed some strong performers, and added selectively to some IT holdings at what believe will prove to be very attractive entry points. In line with our thoughts from last quarter, we would not rule out more ‘unexpected’ surprises ahead.

The market has concerns about Commercial Real Estate and imbalances created by shadow banks for similar reasons. In short, these circumstances replace a similarly unique market consensus of ‘lower forever’ just two years ago, which left several parties holding long-duration assets at low yields that are funded by short-duration liabilities. These are now rising rapidly in cost. Banks, like markets, failed to predict the range of potential outcomes during the depths of the pandemic.

What next? There will likely be some further stresses from the factors above that impact the most exposed monoline business models in particular. Regulators will also respond to each of the issues above, tightening conditions for those banks that are most exposed. This is especially true for previously more lightly-regulated US regional banks. 

It will likely also force assumptions on all banks that deposit outflows will be faster when a bank is stressed, reflecting the new realities of Twitter and mobile banking.

Against this backdrop, there are some relative winners within banks.

The largest banks in the US (and most banks in Europe) are more resilient to these issues. Interest rate exposures and deposit stickiness are already stressed routinely (via a range of oversight measures, such as Liquidity Coverage Ratios, Net Stable Funding Ratios, Interest Rate Risk in the Banking Book) and these banks’ Available For Sale (AFS) portfolio losses are marked to market every quarter. This has kept interest risk lower at those banks and has also pushed them to diversify their earnings. These are diversified, ‘universal’ banks, which cater to a diversified set of customers, and derive profits from different parts of the yield curve and from non-banking businesses. They are away from the eye of the storm.

Equally, while deposits are starting to show movement from current accounts to higher yielding time deposits in the Eurozone, bank regulations are already tighter with respect to liquidity, the yield curve is less inverted, and interest rates have risen less sharply. The latter two factors mitigate both deposit flows and asset risks – the two issues that are front and centre today. If economic and interest rate pressures are able to ease soon, and current market worries abate, these banks will also be in position to earn materially-better returns in the next cycle than they did in the last, which would support long-term valuations.

The extreme change in developed market interest rates illustrates again that preparation, via diversification and sensible regulation, helps manage pain. There will, undoubtedly, be some more pain from such a rapid return to interest rates not seen in developed markets for 15 years. 

But the strongest banks will outperform those fears. We already see some valuation opportunities among them, assuming that a material recession is avoided.

For equities, though, we are less confident on their valuations given the macroeconomic and earnings risks ahead. US equities are still richly valued while European and Asian valuations are cheaper overall (even after considering sector and growth differentials), but we remain more constructive on spreads (credit valuations) than on equities in the current environment.

The events in the banking sector in March are a reminder of the need to be prepared for what we do not know is coming. For us, that means being highly discerning when choosing our investments. Our game plan involves buying the right convertible structure, not just the right stock name. We look for at-the-money, convex convertibles with good credit quality, low distance to the bond floor and enough delta^# to remain exposed to equity upside should the underlying stocks go up in price, but which fall by a lesser degree if the underlying stocks go down. We also focus on companies with better business models and proven free cashflow (FCF) generation capabilities. An example of this is our investment in a convertible issued by a cancer radiology diagnostic provider. This is a BB shadow-rated business, its established activities provided a good bond floor, and the stock was trading at a discount to its fair value. In addition, its clinical pipeline was not priced in by the market, providing further valuation support, while the at-the-money option embedded in the convertible allowed us to participate in the equity upside.

Although new issuance volume year-to-date is running in line with our expectations, with an increased variety of issuers and attractive terms and conditions versus the past couple of years, given our high degree of selectivity, we have only participated in around 13% of new issues this year.

We have a broad universe from which to identify investment opportunities. We look across the entire investment universe (both existing and new issues) when seeking investments with attractive risk-reward properties but, as ever, we remain selective in our approach. We also create opportunities by maintaining flexibility in the way invest. For instance, with a travel and tourism investment, we combined a low-delta convertible with high implied spread for an investmentgrade issuer with a stock position, to benefit from the recovery in travel and tourism. For a Chinese property developer, we invested in two different straight bonds and the stock itself, as we believed the synthetic exchangeable bond was too short-dated and had insufficient delta. For a French hotel chain investment, we chose to invest in its perpetual bond at a high yield rather than its convertible, as we felt the equity valuation was not cheap enough. In Asia, we have invested in a convertible issued by a Chinese food delivery, travel and eCommerce provider. This convertible has relatively low delta but is trading at an implied spread wider than its investment-grade bonds, despite being two years shorter in maturity, and offers an equity option virtually for free.

Selection is critical. Through thorough analysis of the option characteristics and by maintaining a flexible investment approach – comparing opportunities across companies’ corporate structures, instruments (convertibles, straight bonds, stocks) and credit segments (non-rated, investment grade and high yield) – we can choose the convertible structure that we believe offers the best risk-reward opportunity and can deliver better risk-adjusted returns for our clients.

¹ ‘At the money’: when an option’s strike price is the same as the current market price of the underlying security; ‘Busted Convertible’: a convertible bond where the underlying stock trades far below its conversion price.

^# Delta compares the change in price of an option with that of the underlying security. It can help portfolio managers determine   how option prices are likely to rise or fall as the underlying security price varies.