In March, markets were driven by the strong performance of most asset classes, confirming a general trend year-to-date in which investors in most major asset classes have been rewarded with positive returns. In the wake of an equity rally, high yield and convertibles led fixed income markets, but with US rates not far behind. Relatively speaking, investors in certain global rates markets such as Japan and Sweden saw the weakest performance.
Credit markets: caution is warranted, but we see value in European financials
Following the rally we saw in credit markets, valuations for USD credit (HY and IG) and EUR HY no longer offer attractive value, in our view. US IG in particular appears very expensive. Spreads over cash have virtually evaporated, hitting lows not seen since before the subprime crisis over 15 years ago. Compounded with the effect of a high hedging cost, the asset class is even less appealing to Eurozone investors. This is despite the outlook for US IG being rather mixed, with a negative ratings drift and an expected increase in defaults – albeit from an atypically low base. We see pockets of vulnerability for smaller companies in particular, with more restricted access to credit. Overall, however, while we believe that risk is heavily concentrated on the downside, we also don’t see any immediate triggers that lead us to expect a drastic widening in spreads.
On European credit, our view of the market is more polarised. Whilst our view on high yield is also negative, we retain a positive outlook on investment grade. Contrary to their US counterparts, in investment grade, the ratings drift is positive, with substantially more rising stars than fallen angels. While spreads have compressed somewhat, we believe that the yield pickup offered is still interesting in light of risks. The EUR HY market, on the other hand, is far more exposed to tighter financing conditions, especially in vulnerable sectors such as property.
Now that the dust has mostly settled on the SVB failure and the Credit Suisse takeover, we retain faith in strong European financial institutions, which are subject to stronger regulation than their US counterparts (especially vs. US regional banks). With non-financial corporate credit having acted as a “safe haven”, the spread differential offered by many financial issuers is not justified by fundamentals. Nonetheless, we remain prudent from a bottom-up perspective and select only issuers with strong balance sheets (both in terms of asset quality and liability structure) and business models. We prefer national champions.
Despite a strong equity market performance, convertible bonds are presently also offering interesting value and diversification benefits. Share prices stand at levels that offer a high degree of convexity, i.e. these securities are trading at levels where investors have the greatest potential to participate more strongly in equity upside than downside.
US yields may be close to peaking
The shockwaves that the SVB collapse sent through the financial system may ultimately speed the transmission of the Fed’s policy into the broader economy, as financial institutions curtail their lending activity out of prudence. Together with the Fed’s concern about financial stability, this constitutes a backdrop in which the ceiling on Fed hikes seems increasingly hard, and aggressive tightening less likely. Clearly, there is some chance that yields will still rise modestly before they come back down, but we believe that we are both at the right levels and the right point in the cycle to begin building more exposure to US duration. The business cycle is clearly on a downward trajectory, with the chance of recession having increased significantly. Recent data, especially surveys and labour markets, show falls over the last few months. While in part this may reflect the banking crisis, labour market data in particular is a lagging indicator, and the latest data will not even be a reflection of the latest news. Finally, US inflation is now also on an unmistakeably negative trajectory.
In the UK, we also believe that duration is becoming an interesting opportunity. More so than in the US, whose economy appears to be entering a cyclical downturn, the UK economy is showing structural weaknesses. Its economy will not be able to support higher rates to the same extent. With the BOE more dovish than its peers, and an attractive starting point with spreads vs. Treasuries at high levels by historical measures (excepting the spikes last summer caused by political turmoil), we believe this is a good starting point to add exposure to gilts.
We also remain long on New Zealand rates. Perhaps counterintuitively, this is due in part to an extremely hawkish central bank that will not hesitate to push the country into a recession. The surprisingly muted recent market reactions to hikes indicate to us that there is likely significant short interest in New Zealand rates. The possibility of those investors needing to cover their positions adds to the potential of significant downward pressure on yields.
In the Eurozone, after having previously moved to a neutral position in core rates in response to the bank sector turmoil, we now also move from a slightly negative to a neutral position on non-core sovereigns, via Italy. With political risk seemingly attenuated, BTPs not having suffered disproportionate spread widenings during the most recent episode, and less vulnerability in the Italian banking sector vs. several years ago, we believe that the risks no longer justify forgoing the highest roll-down and carry in the Eurozone.
We also see Euro breakeven inflation at interesting levels. Although headline inflation is rapidly decreasing, we expect that core inflation will prove stickier. Even in headline inflation, while overall the disinflationary trajectory should hold, over the medium term, higher demand for energy due to the reopening of the Chinese economy could result in some upside surprises along the way.
Emerging markets: positive on local currency rates and FX, no value in hard currency
Inflation is peaking not only in developed markets, but also in the most relevant emerging economies. Indeed, most major emerging economies (especially Asia, but also Brazil) are currently experiencing lower inflation than developed economies. We should therefore soon see rate cuts, for instance in Brazil and Czechia, pushing rates downwards. We are also positive on CZK, BRL, INR and IDR – these are countries where we are positive both on rates and FX vs. USD. Despite the pivots, we expect that the cooling of the US economy will lead to the USD weakening against these currencies.
Like US corporate debt, hard currency EM debt, however, is in our view simply too richly valued. Spreads vs. US Treasuries do not adequately compensate for the additional risk. Only the very lowest quality issuers – CCC – are offering substantial yield pickups.