In such an environment you don’t have to think very hard to come up with a bear case for almost any asset class. Yet markets will always bottom out at the point of maximum pessimism, so active investors seeking to add value for their clients must simultaneously be alive to the risks in their market but also look through the noise at the opportunities that could lie beyond.
Adam Darling (Investment Manager, Fixed Income) sees the extreme volatility in fixed income markets as presenting an opportunity. “As a bond investor right now,” said Adam, “you have to think about whether current yields provide adequate compensation for the risk regarding the impact of potential future rises in inflation and interest rates. In my opinion, fixed income has gone from being very over valued 12 months ago to being very attractive today.”
“To take sterling investment grade as an example, these are very high-quality bonds with very low risk of default – they’re currently yielding in the region of 5%-6%. I’d argue that investors in sterling investment grade are being more than adequately compensated for inflation risk over the lifetime of these bonds. Similarly for high yield, which is already yielding close to 10%. Personally, my view is that the peak of inflation is happening now, with plenty of indicators suggesting that there may be some aggressive rolling over of inflation expectations as economic pain hits home. On that basis I’m bullish on fixed income as an asset class from here.”
The situation is especially interesting in emerging markets, where for the first time inflation is actually lower than it is in developed markets. Reza Karim (Investment Manager, Fixed Income) specialises in emerging market debt (EMD) and is optimistic about its prospects.
“EMD is a ‘spread asset class’,” said Reza, “meaning that it is priced in reference to US Treasuries, with often quite a high spread. This makes sense in the context of the historically higher inflation and lower quality monetary policy in some emerging markets, but that isn’t the situation we find ourselves in today. It is now the developed markets that have a pronounced inflation problem, and yet the spread over US Treasuries has actually widened, and to us this is a very attractive position to be in as EMD investors.”
“Another area that gives me comfort is that emerging market corporate leverage is now around 2.2x, only slightly more than the lowest it has ever been (it was 1.8x just after the global financial crisis). Such low leverage means that we aren’t facing a solvency issue in EMD. Liquidity is much less good, admittedly, because of the high coupons the market is demanding for refinancing, and as a result new issuance is low and we expect it to remain so for some time. However, the combination of a high yield and low leverage should encourage investors back into the market, in my view.”
Not everywhere in the world is experiencing high inflation in the same way. Japan, for example, isn’t somewhere that has a reputation for inflation – in fact exactly the opposite – as Dan Carter (Investment Manager, Japanese Equities) explain: “Inflation in Japan right now is running at around 3%, which would barely get people raising their eyebrows in other countries. So while directionally Japan is similar to the rest of the developed world when it comes to inflation, we’re talking about a different scale in absolute terms.”
“The good news, from a Japanese equity investor’s perspective, is that I do believe that Japan has a decent population of high-quality companies with pricing power. Also, payout ratios are typically low in Japan, which means that even if earnings take a hit there should still be good cover for dividends, which would support the income return for equity investors. But there are negatives too. In Japan, for example, consumption is particularly fragile and so I would expect that to magnify the impact on companies that are reliant upon consumption to drive their earnings.”
When markets fall it is tough on everybody, but Jason Pidcock (Investment Manager, Asian Equity Income) is philosophical about the challenges. “Just as farmers must endure occasional bad harvests,” said Jason, “investors must endure occasional bear markets. But fundamentally I think equities are a good place to be when inflation is high, provided you’re invested in companies that have pricing power. Of course, most companies are seeing their costs go up right now but some of them are able to pass those higher costs through to their customers much more easily than others.”
“As an income investor, I think a lot about the dividend picture. Clearly, dividends lag profits and so we know that in aggregate dividends will be up this year (they’ve already been declared, based on the last 12 months’ profits). It’s too early, in my view, to say what will happen to dividends in 2023. I would expect, however, that profits will come under pressure and some companies will reduce their dividends. From a stock picker’s point of view we need to think carefully first about which companies may be resilient, but also look through next year into 2024 and beyond with an eye to dividend growth opportunities. That’s the sort of area where I believe active investors can add value for their clients over time.”
Seeking a silver lining in bear markets
The trade-off between income generation today and income growth tomorrow is especially relevant to the world of global high yield bonds, where much of the long-term return comes from clipping coupons and a key area investors can generate alpha is through avoiding defaults.
“Yields today are already pricing in a lot of fear and a lot of inflation risk,” said Adam Darling, “but if we are – as I believe – in an environment where inflation is close to rolling over then that would represent an attractive starting point from a risk/return perspective. But there are plenty of tail risks wherever you look, so today I’m looking for high quality businesses that I believe can survive in any environment. It can be tempting in high yield for people to ‘reach for yield’ and take on additional risk in pursuit of the returns they’re looking for, but the silver lining in bear markets is that you don’t need to do that – if investors do their homework it’s possible to find high quality, resilient businesses, on very compelling yields.”
In conclusion, the key message coming through from our investment experts, whether they be focused on fixed income or equities, is that for long-term investors bear markets create as many opportunities as they do challenges. Clearly it is painful when asset prices fall in absolute terms, but that is also the kind of environment when astute active investors can position their portfolio with an eye to not only reducing downside risk but aligning towards the market rebound that inevitably will manifest in time.
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