Banking crisis may have dented fixed income but opportunities exist
The recent collapse of Silicon Valley Bank and the subsequent acquisition of Credit Suisse by UBS have triggered concerns about contagion within the broader financial sector and raised questions about global monetary policy.
Central banks now face the challenge of maintaining financial stability while also controlling inflation amid heightened geopolitical uncertainty and the looming threat of a global recession.
This convergence of adverse factors has created an atypical situation for investors.
Last year, traditionally defensive fixed-income assets such as government bonds and investment-grade credit failed to provide the expected performance during economic contractions. Stocks did not fare any better. However, recent market trends suggest a potential shift towards a recovery regime, with riskier assets such as high-yield credit performing better. Nonetheless, much depends on the future trajectory of interest rates.
Market participants currently expect a peak in interest rates by mid-2023, with inflation expected to decline and the US Federal Reserve approaching the end of its fiscal tightening.
However, caution is warranted, given that on April 3, Opec and its allies, including Russia, decided to cut crude production by a combined 3.6 per cent of global demand.
If high inflation persists, central banks may not hesitate to reduce rates. The danger is that a prolonged period of high inflation and the resulting central bank response of higher interest rates could lead to an economic slowdown. This would lead to a further deceleration of the global economy and a continued contraction regime in the coming months, with below-trend growth and a risk of a recession.
Despite these challenges, we believe there are opportunities for investors to find returns in fixed income. Throughout the current contraction regime, we have adopted a more defensive stance while still recognising opportunities for investors in investment-grade debt and high yields. Despite the challenges faced by fixed-income assets last year, the higher bond yields, weaker economies and central banks halting rate increases may render 2023 a more favourable year.
It is important to note that US credit spreads widened towards historical norms last year. Even though they remain short of those benchmarks, there is the potential for credit spreads to widen further if economies weaken.
However, we note a recent narrowing as markets start to look forward to an end to central bank tightening and an eventual economic recovery.
Even if we allow for a slight widening of those spreads, our projections suggest that total returns on credit will be higher than that on government debt this year.
Emerging market (EM) fixed-income assets appear more attractive than their developed market counterparts, based on the assumption of narrowing spreads. Additionally, we expect that local currency versions of EM debt will outperform hard currency versions, albeit with more volatility, as the US dollar weakens this year.
The Russia-Ukraine conflict has significantly affected the energy mix for European countries, forcing governments to prioritise energy resilience over energy transition in the short term. This led to a strong performance for oil and gas stocks last year. If Opec and its allies continue to pursue a hawkish approach to cutting production, such stocks will continue to perform well into the medium term.
Fixed-income and environmental, social and governance investments are poised for growth this year. Private credit also remains a robust option for portfolio diversification, offering enhanced income due to exposure to additional credit and liquidity risk.
The fixed-income outlook for this year will require investors to navigate a turbulent financial landscape carefully.
Central banks’ responses to inflation, geopolitical tension and the performance of various asset classes will all play a role in shaping investment strategies.
Despite these challenges, opportunities still exist for investors to find returns in fixed income, particularly within emerging markets, ESG investments and private credit. Maintaining a diversified portfolio will be essential to weathering the storms of an uncertain global economy.
The fixed-income outlook for this year will require investors to navigate a turbulent financial landscape carefully