Investment in a Minute - As Inflation Genie Lingers, Banks Look Good

Which sector(s) do you find the most attractive?

One area where we are finding compelling value right now is in financials, especially in banks. We believe that banks today are in a much better shape than in 2008, being strongly capitalised and well placed to withstand a recessionary environment. Banks also generally benefit from higher interest rates, since they are able to capture a wider spread between their lending and deposit rates.

Despite these positive factors, banks currently trade at a significant discount to other sectors having sold off sharply in 2022.

Another area that we find interesting is the perceived attractiveness of certain government bonds.

The risk-reward in five-year US Treasuries has improved. It took 10 months of US inflation above 5% (on a year-over-year basis) before the US Federal Reserve hiked interest rates for the first time in March 2022. The Fed has been playing catch-up ever since, and has hiked rates at breakneck speed while simultaneously reducing the size of its balance sheet. Given the lagged effects of tighter monetary policy we now see some signs inflation is on a downward trajectory in the US and in many parts of the world.

While our base case scenario is for interest rates to remain higher for longer, the current environment of higher government bond yields combined with declining inflation has improved the risk/reward profile of some government bonds, in our view.

Where do you think opportunities are most underrated and why?

After a significant re-pricing in both credit spreads and the risk-free rate throughout 2022, we think investment grade credit offers compelling value. For perhaps the first time in over a decade, we believe investors are being well paid to take both credit and interest rate risk.

This is perhaps best illustrated by the fact that corporate bond yields are today all in positive territory – the era of negatively yielding corporate debt is finally at an end.

Investment grade corporate bonds also look well placed to withstand a more recessionary environment – despite the uncertain economic outlook, corporate fundamentals remain strong and we expect default rates to stay low. While spreads have tightened a little in recent weeks, implied default rates in the BBB space remain well in excess of the worst defaults experienced. In other words, we believe that investors continue to be well-compensated against the risk of default.

Why Fixed Income investments?

Bond markets experienced one of their sharpest sell-offs on record in 2022, as concerns over persistently high inflation forced central banks to take a far more aggressive monetary policy stance. However, given the scale of these moves we believe fixed income investors go into 2023 on a much better starting point and we see compelling value across many parts of the asset class. We would also expect inflation to gradually ease throughout 2023, helped by lower commodity prices, slowing growth and base effects. After a brutal year for fixed income, we think this will allow central banks to slow their pace of rate hikes, which could provide a very welcome tailwind for bond markets.