Green bond premiums to return as market digests bumper issuance
Rhys Petheram, Head of Environmental Solutions, looks at trends in fixed income markets over the past several weeks, as significant volatility in yields has had multiple underlying causes. What are the implications for markets, especially in the sustainable fixed income world of green bonds?
The most important move in fixed income markets over the past week, at least in the context of sustainable fixed income, was the move in US Treasuries.
To be clear, US Treasuries don’t pass our UN Global Compact screens so we wouldn’t consider any US Treasury green bond part of the sustainable fixed income, but it is nevertheless the most important asset class in the fixed income world in general. The shift higher for yields comes as the market continues to digest the implications of a more aggressive Fed, with the first rate hike priced in for March and four over the year, as well as increased expectations around quantitative tightening in the second half of the year.
What’s different between the move higher in yields we’ve seen so far in January, compared to what we saw in December, is that the December move was all about increasing inflation expectations. Those have all completely reversed (as evidence by the inflation-linked bonds market) and the higher yields now are entirely driven by term premia, the risk premium baked into government bonds. In my view this is linked to the market’s views around quantitative tightening.
What’s interesting about this for me, as a sustainable fixed income investor, is that credit spreads are wider at the margin, but in general have barely moved. One key reason for that lack of movement is that yields are reasonably high, for example US investment grade offers around a 2.6% yield. Within sustainable bonds there has been a normalisation of valuations towards the ‘unlabelled’ green bond space, which is especially evident in new issuance coming to the market, due to an influx of supply late last year when $1 trillion was issues in green/social/sustainable bonds. That was a lot for the market to digest in one go, but I think it would be challenging to see that scale of issuance repeated in 2022. While supply of green bonds may pull back a bit, demand is set to remain high and I think that should see premiums for green bonds return.
Thinking for a moment about some of the environmental solution themes we look at… I saw an article recently discussing holiday gift returns in the US, which are expected by UPS to result in 60 million packages being sent back to retailers. Those retailers will need to absorb the increased cost of these returns, but it’s not just a financial burden but also an environmental one – a lot of those returns will be landfilled or incinerated, and companies will bare the risk of managing that waste in a responsible way in light of consumer and regulatory focus on environmental factors. This links directly to the ‘circular economy’ theme in our environmental solutions world, as companies emerge to help industry recycle, re-purpose, re-use and otherwise manage their waste.
‘Late and wrong’: the Fed keeps fumbling policy
Richard Buxton, Head of Strategy, UK Alpha, looks at the curious policy decision of central bankers, most notably the Federal Reserve, as they continue to pursue a reactive policy agenda that means their decisions are likely to be ‘late and wrong’.
In a brief window last October, before Omicron, I was able to visit the now-Octogenarian who gave me my first job in the City. Still razor-sharp of mind, he asked me why central banks these days have become so data dependent, when monetary policy works on a 12-18 month lag and the effect of any change in policy is cumulative with each incremental move. Surely, he said, central bankers should spend their time judging what the effect of today’s policies will be in a year or two, rather than reacting to the latest data prints which will inevitably make them, in his words, “late and wrong”.
How true those words are! We know that the Fed over-tightened policy in 2018, but it wasn’t until Wall Street fell 20% that Powell orchestrated his infamous ‘pivot’. It’s crystal clear – or at least it is to me – that the Fed should have been withdrawing stimulus last spring, when all the signs were there, and if they had done so they could have tightened again come the autumn. Instead, we find ourselves in a position today when the Fed is openly behind the curve and we have inflation.
The key question now is whether wage inflation will cause the Fed to tighten even if the economic data continues to soften, or will they plow on regardless. If Wall Street fell, would the ‘Fed put’ assert itself once more? Or would the Fed feel obliged to help Biden in the troublesome mid-term elections by continuing to act tough on inflation regardless of the impact on markets? Only time will tell.
Lastly, thinking back to the energy crisis a few months ago, it has been a mercifully mild winter in Europe and the UK so we haven’t yet had to have any outages of heavy industrial users of power. But this doesn’t mean we’ve sold the energy crisis, nor the impact on the consumer or the balance of generation methods in the overall grid as greener but less consistent renewable methods take a larger share. Reading the political tea leaves reveals a fairly obvious continuance of the swing of the pendulum from capital in the direction of labour, with higher corporate taxes and higher wages on the way, as politicians seek to limit the capacity of the energy sector to make profits.
All these uncertainties make for a challenging year ahead.
India sends bullish signals
Avinash Vazirani, Fund Manager, Global Emerging Markets, expects India’s stock market to remain supported by improving growth picture and a young population that’s allocating savings to equities.
There are quite a few statistics from India that look encouraging. Market capitalisation and gross domestic product of both India and the UK are now almost similar, while India’s software services exports are now greater than Saudi Arabia’s oil exports.
Over the last few years, India has moved from a service-led economy to a truly tech-led economy. Last year there were 42 new tech ‘unicorns’ and tech fundraising totalled $43 billion. India is now the third-largest tech start-up ecosystem in the world after the US and China.
What is more, India’s GDP is now greater than pre-Covid levels, with government finances on a better footing as businesses are doing well and tax compliance is improving. The banking system is in great shape too. This is all evidenced by India’s corporate earnings growth of 36% (FY23 over FY21) which is the second highest globally. This compares with China (27%), the U.S. (18%) and the UK (9%).
What we’re seeing now is that growth is moving from consumption on to manufacturing and industrials. We think this is the start of a new cycle and mirrors what we saw in 2003 to 2009.
What has been another distinguishing factor is that domestic investors are moving towards investing in equities. India has a young population that’s now decided to allocate savings to equities. Last year $2 billion a month went into domestic equity mutual funds, and it is continuing at a similar pace this year as well.
Although the Indian market is expensive (it’s now trading at 23.5 times earnings) and may correct along with global markets, we think the positive underlying factors highlighted above provide some downside mitigation on a market level. Plus, domestic flows into equities may continue as most of the money that is coming in now is from monthly savings plan.
Despite value rally, uncertainty dominates
2022 has started with a value rally, but investor uncertainty remains very high, says Amadeo Alentorn, Head of Systematic Equities.
Markets have kicked off 2022 with a strong rotation away from growth stocks (companies with faster than average growth in revenues or profits) and into value stocks (companies relatively cheaper on metrics such as price to book or price to earnings). Returns from a value style of investing, so far in January, have been some of the strongest we’ve observed in recent years.
To some extent this is a continuation of what happened in December. While markets in the second half of 2021 were mostly growth-dominated, from December there has been an increase in investor risk appetite, and a rotation away from more expensive, quality growth stocks, towards cheaper, more risky value stocks. This rotation has continued and even accelerated at the beginning of January 2022.
Not a junk rally
That said, we are also continuing to observe a very diversified market. This is not a classic ‘junk rally’, where all the action is in cheap, risky, stocks. Instead, like last year, a well-diversified set of investment styles is playing out.
For example, investing based on identifying high quality company management teams is continuing to work well, just as it did last year. This is not a classic junk rally where all low-quality companies are rising. Also working well at the moment are styles based on stock analysts’ information and its effect on short-term investor sentiment, as well as long term reversals (an investment style based on looking at long-term stock price trends and identifying stocks that have diverged from fundamentals, become overpriced, and are ripe for price rectification).
The market is well-diversified in terms of attractive investment opportunities, in our view.
Uncertainty is high
As we look forward to the rest of 2022, the uncertainty and dispersion of the current market environment is high. The whole of 2021 was dominated by high levels of investor uncertainty. It’s the same story now across all regions we model worldwide: we measure them all to be at either high or medium levels of uncertainty.
Momentum (or trend following) investing can be very risky in high-uncertainty markets. While we are slightly pro-value and risk-on right now, this can change very quickly, as we saw last year.
Last year started in a very similar way, with a value rally in the first half of the year, which evaporated quickly during the summer, for the market to finish 2021 in a growth environment. While uncertainty remains so high, markets can be very changeable.
Differentiation is key in EMD
Alejandro Di Bernardo, Credit Analyst, Emerging Market Debt, explains why it’s a good time to invest in EMD, but it’s all about differentiation.
It has been a tricky start to the year for emerging markets, after a risk-on December. On the corporate side, the JPM CEMBI Broad Diversified Index is down around 150bps so far this year, driven in part by China, which accounts for roughly 5% of the index. At the same time, in terms of sovereign bonds, the JPM EMBI Broad Diversified index is down around 270bps, led by investment grade countries.
To date, January’s performance has been driven by systematic and idiosyncratic factors. We’re seeing a policy shift in the developed world, with rising interest rates, as well as higher energy prices and inflation. We also have several elections coming up this year in EM, which further adds to asset class volatility. On the FX side, it’s hard to predict US dollar moves, which will depend on whether the US Federal Reserve (Fed) tightens less or more than expected, as well as developments in China.
As a team, the question we ask ourselves is, what’s in the price, given how bearish the market is right now? From a risk-reward perspective, EMD is at the cheapest it’s been in the past five years. We believe the asset class provides a valuation cushion, and it’s extremely diversified, across around 100 countries.
In this environment we favour credit default swaps as hedges, as well as companies with natural hedges like exporters that can support cashflows, and we’re able to identify BB names with enough spreads and good fundamentals to potentially cushion against volatile rates. We see the current environment as a great opportunity for bonds in companies with improving cash flows, good stories and high yield, which should benefit when the market turns.
The value of active minds: independent thinking
A key feature of Jupiter’s investment approach is that we eschew the adoption of a house view, instead preferring to allow our specialist fund managers to formulate their own opinions on their asset class. As a result, it should be noted that any views expressed – including on matters relating to environmental, social and governance considerations – are those of the author(s), and may differ from views held by other Jupiter investment professionals.
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