2022 was an extraordinary year in investment markets, with a lot of eye-catching stats. One that stands out to me is that it was the first year since at least 1870 that both the US stock market and US long-dated Treasury bonds have fallen by more than 10%. The word ‘unprecedented’ has been used a lot in the past few years, but that really was an unprecedented occurrence.

A lot of the fear in markets was around inflation, and central bankers have arguably fallen short in their attempts at giving policy guidance to markets. Don’t forget that in 2021 the Federal Reserve was talking about ‘average inflation targeting’ and saying it would be prepared to let inflation run hot and not be too proactive with policy. Yet in 2022 the Fed moved rates from 0.25% to 4.5%.

At the same time as this turmoil around inflation and interest rates, there was obviously also a lot of geopolitical strife. A lot could be said about the outlook for inflation and interest rates (which I’ll get to later) but we know that this is essentially a cyclical process. Geopolitical tensions are a different story, and unfortunately I expect geopolitical concerns to remain an issue in 2023 and probably for at least a few more years thereafter. Even aside from Russia’s actions, we know we’re moving from a unipolar world of US dominance following the end of the Cold War to a bipolar world where China is an ever more viable challenger to the US sphere of influence both economically and militarily.

Heightened non-linear risks are something that active fund managers need to be aware of. My own specialism is global sovereign bonds, and issues I’m keeping a close eye on are China/Taiwan – where for example a short position in the Taiwanese dollar seems like a sensible hedge to me. In the gulf region, countries such as Saudi Arabia and the UAE have historically been aligned to the US, with oil contracts denominated in US dollars and a flow of militarily contracts going in the opposite direction. Yet last year Saudi Arabia announced an oil deal in Chinese yuan, which could indicate the start of a shift in loyalty for the region. Global sovereign bond markets aren’t really priced for a lot of volatility in this region, so it’s an area where investors can buy relatively cheap protection, taking short exposure without having to pay much for it.

After a such a brutal year in 2022, it was notable that last week there was a point at which there were no longer any negative-yielding sovereign bonds in the world. Yield returning to the asset class is a real silver lining for bond investors. It is, after all, supposed to be an income asset class at its core. Investors are now being paid to wait, with even portfolios of high-quality bonds yielding in the high single digits, with high yield portfolios in the double digits to compensate for the greater credit risk.

How to manage credit risk will be key for bond investors in 2023. We’re headed for recession, and so I expect fears about duration will be replaced by fears about credit quality. Inflation is at or around its peak now, I believe, and although central bankers are still talking tough I think we may even see a deflationary shock at some point this year as recession starts to bite on the economy and base effects naturally weigh on headline inflation figures. The US economy has been resilient so far when other places in the world have struggled, but forward-looking indicators have become notably softer so I see a lot of downside risks to growth in 2023.

In that kind of environment is important to be careful about credit risk, to stay active, and do detailed due diligence on individual issuers as defaults will surely rise and avoiding them is key to outperforming in this asset class.

The value of active minds: independent thinking

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