At an investment crossroads: being flexible to find good entry points

11 min read 11 Jul 23

The ongoing rollercoaster ride through the macro and market landscape might not be getting any smoother, but recent shifts in direction should give investors conviction for how they position their portfolios across fixed income and equities.

For investors who can be nimble, we believe some of the key opportunities in the second half of 2023 across asset classes include:

  • A preference for European and Asian equities over the US, given that the latter now looks expensive versus the rest of the world
  • Government bonds as ‘safe haven’ diversifiers, along with high-quality corporate issuers.
  • The elevated carry from select emerging markets (EM) currencies

These entry points aren’t necessarily what we expected when the year began. At that time, among the prevailing narratives in the market were: inflation conquered; central bank policy rates peaking by the end of the first quarter; an imminent recession in Europe following the impact of energy prices on consumers; and a relentless surge in growth in China spurred by its re-opening.

Finding a new path to resilient and diversified returns

Inflation is still around, but we believe the trajectory is more disinflationary. In fact, second-quarter data from the US produced other surprises, with the labour market now top of mind. This reflects the fact we are gradually seeing the early signs of a slowdown, including jobless claims on the rise.

This scenario creates a dilemma for the US Federal Reserve (Fed). While the signs of more unemployment in the US suggest rate hikes are starting to have an impact, the Fed must balance the desire for a couple more hikes with the likelihood of that same action triggering further job losses. We therefore expect increasing pressure for a prolonged pause.

Either way, as economies start to slow, we believe that will be the green light for central banks across various developed markets to start cutting rates in 2024.

Further, with elevated front-end yields due to the revival in bonds, coupled with recent bank stress, depositors have been seeking an alternative to traditional deposit accounts. As deposits at many smaller and medium-sized regional US banks have shrunk as customers favour larger banks, the potential macroeconomic implications are precarious.

For example, many businesses in the US are financed by regional institutions. As a result, the cost of borrowing is rising – a situation likely to put further pressure on the Fed’s intentions to raise rates between now and the end of the year.

At the same time, after seeing Europe and China perform well initially in 2023, more recent economic data has been disappointing. In response, investors are asking questions about where the potential for returns from these markets might come from.

For the rest of 2023, we are watching closely to see how various market, macro and geopolitical dynamics play out to steer portfolio allocations across asset classes:

  • US recession – what impact will the confluence of higher rates, tighter bank lending norms and new Treasury issuance have on economic growth?
  • Second quarter earnings revisions – while equity markets have been remarkably resilient, better-than-feared first quarter earnings were largely achieved before the US banking stress.
  • Long-term inflation expectations – these remain anchored, suggesting a relatively swift return to targets, yet some recent projections indicate a level of around 3% by year end.
  • China – there has been a shift in narrative from ‘re-opening’ to ‘stimulus’ as the domestic economic recovery matures. So what’s next?
  • Geopolitical events – the implications of ongoing tension of different kinds between Russia/Ukraine and US/China remain unknown at this stage. 

Reaping rewards from an all-in rebound

The macro and market backdrop continues to be favourable for all types of fixed income – from the most liquid and highest quality issuers, to local currency EM and high yield (HY) names on a selective basis.

Performance in the first half of 2023 has been welcome after the torrid time for the asset class for much of 2022. “Valuations have readjusted dramatically over the course of this year,” said Jim Leaviss, CIO Public Fixed Income. “In general, we see a better starting point for bonds.”

More specifically, HY and investment grade (IG) corporate bonds have delivered low single-digit returns year-to-date. And at the short end of the curve, investors have benefitted from some dramatic movement. For example, 2-year US Treasuries, 2-year UK Gilts and 2-year German Bunds are up between 375 and 400 basis points (bps)1. Further, corporate bond yields are at their highest levels in over 10 years.

In particular, EM local currency bonds were the stand-out asset in the fixed income universe as of mid-June, giving investors high single digits, and reflecting the value that returned to corporate and government bonds in emerging economies.

Being near the end of the prolonged Fed-led interest rate hiking cycle in developed markets has also made bond yields more attractive over time.

The 30-year US Treasuries are a case in point, offering buy-and-hold portfolios a return of 1.5%, plus inflation. “This is the first time in over a decade that this has been possible,” explained Leaviss, “offering a great opportunity for longer term investors.”

The renewed resilience in the bond markets bodes well for high-quality issuers for the rest of 2023, especially in the face of a looming US recession.

With 5-year IG US treasuries, for instance, the spread component of around 150 bps (as of June) gives a credit spread that Leaviss believes should adequately compensate investors in a recessionary environment.

For EM exposure, since some currencies look relatively cheap at the moment, Leaviss said flexible bond funds are able to capitalize on this. Being nimble can also help investors capture the higher potential growth rates EM offer compared with their developed market peers, spurred by the much lower government debt levels in EM relative to the size of their economies, plus better valuations.

“Given that many EM central banks are hiking rates, most EM real yields remain elevated versus the developed markets,” added Leaviss.

For example, when looking at real yields on 10-year sovereigns, minus forward looking inflation expectations, countries like Brazil, South Africa and the Philippines are at around 6%, followed by Peru, Mexico, Columbia, India and Indonesia at around 4% to 4.5%. This compares favourably with the US at just under 2.5%, said Leaviss.

1. Source: Bloomberg, M&G, 15 June 2023

Flourishing from strong fundamentals

Amid the strong performance of EM assets globally, Asia stands out, with its solid macro fundamentals.

“Global investors should start to look at Asian fixed income for new growth opportunities going forward,” said Guan Yi Low, Asia Head of Fixed Income.

The asset class has also been largely unaffected by the recent shifts in monetary policy expectations. Despite the Fed being more hawkish than expected, Indonesian and Indian government bonds, for example, have delivered positive returns, with bond yields in both markets falling in the first half of 2023 and their currencies appreciating against the US dollar. “We expect to see a similar resilience in other Asian bond markets over the rest of the year,” added Low.

She also earmarked the region to ease monetary policy in 2024, based on expectations that inflation will fall within, or to, policy targets by year end.

As far as Asian currencies go, Low expects renewed investor appetite to be supportive, after a difficult couple of years amid the sharp economic slowdowns and volatile global markets.

China should also remain a source of optimism for fixed income investors. Even though the pace of recovery has faltered since the first quarter of 2023, Low believes the government’s 5% growth target for this year is realistic, especially given recent evidence that the People’s Bank of China, the central bank, is ready and willing to stabilize and drive growth.

Investors also hope that some of these supportive policies will target the property sector, given the importance of this sector for domestic investors.

Within the fixed income opportunity set, even though the weight of Chinese real estate developers in the Asian HY universe has halved over the past two years following defaults and debt concerns, the sector still plays a significant role in the outlook for Asian HY.

“While we expect more measures to be introduced to stabilise the underlying property market, however, the bifurcation between the higher quality real estate issuers versus the smaller, private issuers will continue,” added Low.

Further, while the generally higher-for-longer environment might put added pressure on financing the corporate sector, Pierre Chartres, Investment Director, Fixed Income, said that, on average, the starting point is generally strong for a lot of companies.

“Many corporate balance sheets have become more resilient after benefiting from the previous low interest rates,” he explained. “Net leverage is low and interest coverage remains close to all-time highs. This should provide some support going forward.”

In line with this, investors are more likely to benefit from focusing on quality names and being selective, added Chartres. “We prefer companies in the less cyclical sectors, especially those companies that have been able to pass on higher input costs to customers.”

Rebalancing portfolios as equities regain ground

Beyond bonds, cross-asset performance so far in 2023 appears to show a clear pattern of returns being dominated by long duration, growth equity markets.

On the flipside, bond markets and commodities appear to be pricing a slower growth environment for the second half of the year. In short, despite their rebound from 2022, bond markets haven’t been able to keep pace with equity markets.

“Equity markets have been taking the opportunity to rally whenever they have had the chance. Any good news has been rewarded with performance,” said Michael Dyer, Investment Director, Multi Asset and Equities.

A disciplined approach has also been key, alongside the ability to be flexible. “A common discussion with investors has been to avoid wasting efforts on assets where we are not getting paid enough to take the risk,” he added, “and instead wait for good entry points which are more aligned with more attractive valuations.”

At the same time, the rest of 2023 looks potentially precarious, as nerves start to creep in due to the increasing fragility in the US economy and the growing likelihood of recession.

Investor sentiment reflects the wariness. “Equity and bond markets are sending inconsistent signals about their perception of risk,” said Dyer. “Equity volatility remains subdued while bond market volatility is elevated. However, in the second half of the year, we expect a pick-up in equity volatility.”

And from a valuations perspective, cash and bond yields are pushing new highs while equity earnings yields remain below October levels. This is creating good opportunities for stock picking, basing selections on valuations.

As investors assess opportunities by region, Dyer thinks Europe and Asia look more attractive than the US. “After a protracted period of outperformance, given by substantial earnings delivery, US stocks now look expensive versus the rest of the world.”

Yet multi-asset approaches cannot overlook the need to be well diversified. As a result, with government bond valuations restored, correlations with equities have declined, in turn enabling government bond markets to regain some credibility as potential ‘safe haven’ diversifiers.

Dyer also sees opportunities from the elevated carry available with certain currencies, to provide a margin of safety for future spot price volatility.

Key reasons to take a flexible approach in today’s uncertain markets

  • Despite strengthening recessionary forces, a more disinflationary trajectory offers emerging opportunities for investors who can be nimble across asset classes in the second half of 2023.
  • The confluence of higher rates, tighter bank lending norms and new Treasury issuance looks likely to dampen the potential for economic growth for some time.
  • Value continues to be found across the fixed income universe – from government bonds and investment grade corporate credit, to emerging markets (EM) debt and selective high yield names.
  • Renewed resilience in the bond markets bodes particularly well for high-quality issuers for the rest of 2023, especially in the face of a looming US recession.
  • Certain EM currencies look relatively cheap, enabling flexible bond funds to capture the higher potential growth rates that EM offer compared with developed market peers.
  • Asia’s strong macro fundamentals are positive for local fixed income in the region, such as Indonesian and Indian government bonds.
  • China should remain a source of optimism for fixed income investors, given central bank support and expectations of more policies to further stabilize the property sector.
  • Good entry points are re-emerging in equity markets, with returns being dominated by long duration, growth equity markets.
  • After a protracted period of outperformance, given by substantial earnings delivery, US stocks now look expensive versus Europe and Asia.
By Jim Leaviss, Guan Yi Low, Pierre Chartres and Michael Dyer

The views expressed in this document should not be taken as a recommendation, advice or forecast. Past performance is not a guide to future performance. The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested.

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