29 DEC, 2022
By RankiaPro Europe
By Eoin Walsh, Partner, Portfolio Management, TwentyFour Asset Management
After what is on course to be one of the worst years on record for the performance of a typical 60-40 portfolio, the vast majority of investors globally will be impatient to leave 2022 behind and focus on their prospects for the year ahead.
There is good reason for fixed income investors to expect better in 2023. Markets have taken a lot of pain, and on top of that, they look to have priced in a substantial amount of bad news already. Although, we think we are unlikely to see a straight-line recovery such as the one we enjoyed from April 2020 through mid-2021, for example, but given current yields, we believe fixed income markets are well placed to produce positive returns in 2023.
Banks look compelling across the capital stack, as do high quality European RMBS and CLOs where we think spreads can tighten significantly. The speed and scale of the 2022 downturn means that even short dated investment grade bonds are yielding more than at any point since the global financial crisis, so we see good value opportunities even at the higher quality, safer end of the traditional risk spectrum. Since we anticipate an uneven recovery we think the best fixed income opportunities will be stock specific in 2023, but there is no denying that starting yields across the asset class mean we also think investors won’t need to reach for risk to generate positive returns.
The last 11 months could perhaps be summarised as markets’ fear of the unknown, or rather a series of unknowns: inflation, monetary policy, supply chain disruption, the war in Ukraine, a European energy crisis, China’s COVID policy, political turmoil in the UK, the resilience of the consumer, the timing and depth of recession. If there is a positive to be taken from a torrid 2022, then it is that the rapid pace of this cycle has helped to remove or at least reduce a good portion of these unknowns.
US inflation looks to have finally turned and we think could come down quite rapidly over the next six months. We believe we are very close to terminal rates in the US, and we look to have more certainty around the Fed’s plans today than we have at any point during 2022. Given the scale of the sell-off it was no surprise to see a succession of bear market rallies emerge as this year progressed, but we believe the strong recovery in credit following the landmark US inflation print in early November feels overdue and well justified. The simultaneous comeback of primary market supply has shown investors have plenty of cash on the side-lines, and more importantly are ready to put it to work.
Forecasting geopolitical crises is typically unproductive, but recent developments in the Russia-Ukraine war would appear to suggest the most severe scenarios can be avoided. On a related note, it appears the worse-case scenario of blackouts and energy rationing in Europe this winter should also be avoided, thanks to a softening of prices and successful efforts to source alternatives to Russian supply.
By far the biggest positive for 2023 though is starting yields across fixed income, which in our view are still pricing in far more bad news than we are likely to see in the next 12 months. Breakeven yields are now offering bondholders substantial downside mitigation, and we think investors can build their portfolios for 2023 without fearing the same level of disruption they faced in 2022.
Of the unknowns that remain, we believe the most significant is the amount of damage ‘high for longer’ rates might do to economic fundamentals. In macro terms, broadly we see three potential outcomes in 2023:
Our outlook for global growth is more positive, with the potential for a relaxation of China’s zero-COVID policy being a welcome and potentially significant development. We expect global GDP growth to exceed 2% in 2023, higher than in the US or Europe.
In our view, 2023 is a year for fixed income investors to be very stock specific. Again, we anticipate an uneven recovery, and central banks are only just beginning their exit from an unprecedented era of low rates and liquidity provision; it is difficult for anyone to predict how this unwind could impact asset performance in the next 12 months and beyond. Volatility can cause fractures in areas that weren’t previously a cause for concern, as the UK’s Gilt sell-off and subsequent pension fund crisis at the start of Q4 neatly demonstrated. Equally the recent non-calls of hybrid bonds issued by several Real Estate Investment Trusts (aka REITs), for example, will increase scrutiny of that industry going forward.
The pain taken this year has left high quality companies trading at yields that rarely persist for very long, and as we approach year-end there is plenty of evidence from primary markets that buyers are coming off the side-lines looking to take advantage of the value opportunities available. For the first time in a long time, we see attractive value available in most parts of fixed income; rates can now give you yield and downside mitigation, while across credit yields are at near-decade highs, and confidence was high that investors could enjoy strong 12-month returns.
Some of the greatest confidence expressed in our discussions was in the resilience and attractiveness of the financials sector. Having IG rated banks and insurance companies with debt outstanding that yields up to 10%, or even more in some cases, is very unusual and unlikely to persist for a long period of time in our view. With attractive value options available across the debt stack, this was the sector where there was most optimism and we think it should be towards the top of the best performing sectors list next year. In addition, for those investors who can take slightly less liquid bonds, the CLO sector looks particularly attractive to us, and even without any capital gain the returns here could be attractive.
We think starting yields are giving fixed income a decent head start on potential returns for 2023, and crucially in our view investors don’t need to reach for risk to build a high income portfolio profile with potential for some capital gain as well.