The end of 2022 was tough for fixed income markets. Many were positioned for a re-pricing in credit and equities in line with a slowing economic environment in the US and Europe, but the price action didn’t materialise. Instead, the US Federal Reserve (Fed) and European Central Bank (ECB) gave fairly hawkish statements, reiterating their commitment to tackling inflation by raising interest rates, with no hint of a much-anticipated ‘pivot’ in policy direction, despite data suggesting inflation had peaked in both economies.
You could say ‘good’ economic news got a bad response, triggering some big market moves with the yield on 30-year Treasuries reaching 3.95%. Duration, credit and equities all sold off, displaying an unusual – and surely unsustainable? ─ cross-asset class correlation.
As we navigate our way through January, it seems the situation has reversed. Now, ‘bad’ economic news is being treated as good news by markets.
What do I mean by this?
Essentially, the market has taken the view that slowing growth and recession will be ‘good’ as that will force the Fed to cut rates sooner. In addition, easing inflation should lead to a less restrictive monetary environment in H2 23 – it’s pricing this in now.
Right now, the inverted yield curve in bond markets is saying we’re going into recession, but credit and equity markets don’t agree. The market is fighting the Fed.
This unusual conflict between different areas of the market is the big complication for investors today.
We’re anticipating a pretty volatile Q1 and need more clarity on economic direction in the US and Europe, especially regarding employment and inflation, before we can build a firm view for the half-year.
So, what do we do now?
In the absence of a much-wished-for crystal ball, we turn our attention to bottom-up factors; you have to be even more aware of fundamentals when the top-down is so mirky. Our approach is to go up in quality on the bonds we’re buying. Improved downside protection in the credits and sectors we’re looking at provides a way of mitigating macro uncertainty.
In terms of sectors, we continue to avoid housing following a significant sell-off. Similarly, energy, which is likely to come off as demand begins to soften going into spring.
We’re focusing on picking the right spots among cyclicals – we continue to like some of the investment-grade big tech names. We’re also looking at select retail opportunities and some financials, which may seem contradictory given that’s the sector most leveraged to an economic recovery, but the volatility in rates also offers opportunity.
In Europe, we’re thinking about putting credit hedges back on, with the view that we might have a re-pricing of credit risk because the market is not pricing in the risk of recession (again, the market is pushing back against a hawkish ECB, mirroring the situation with the Fed).
Lastly, we think EM is looking interesting again – as US rates peak and the economic environment shifts, the dollar should weaken, which would be good for EM and the commodity-exporting economies. We’re also considering the China re-opening trade and what opportunities this could create around the world.
Overall, as we wade through a murky macro landscape, our attention is firmly focused on rigorous bottom-up analysis. The real difficulty will be if inflation remains high and the Fed continues to raise rates – then all bets will be off…