Changes in market regime are rare and significant events.
The pandemic may have receded, but the impacts of its radical challenge to conventional fiscal and monetary policies will be with us for years to come.
We now know that 2020 brought the curtain down on a fixed income bull market that persisted for almost four decades.
At the same time, powerful inflationary forces were unlocked across many developed economies – forces that were accelerated by Russia’s invasion of Ukraine last year.
Most major fixed income markets are attractive at present.At several points during the past decade, we worried that our debates about the end of the era of low interest rates were merely academic.
But the moment we realised that the intellectual and political approach to fiscal policy had been changed by Covid-19 was the moment we appreciated the power of the forces at play – and their significance for yields and interest rates.
Last year was characterised by rapidly rising rates across the western world, monetary withdrawal and a severe repricing of both equities and bonds. There was nowhere for investors to hide: for much of the year, moving from equities to bonds meant moving from the frying pan into the fire.
This challenging correlation between price moves and what were perceived as safer assets took investors by surprise and defied conventional wisdom. Investment managers have been forced into a wholesale rethink of the role fixed income assets can play in their portfolios.
Today, with yields in our view attractive, we believe bonds are decisively back.
The key question then becomes: where do we believe the opportunities lie?
Prepping for recession
If, as seems likely, rates go high enough to drive up unemployment, we will eventually find ourselves in recession, and recessions typically mean difficulties for risk assets.
The longer economic resilience in the US can be maintained, the more the US Federal Reserve is likely to remain hawkish, and the more pressure there will be on yields to drift higher.
If and when a recession transpires, we believe it is possible to continue to thrive through strategic, active management of credit risk and exposure to duration and interest rates, positioning for opportunities as they arise.
It is likely that more unexpected pockets of vulnerability will appear. Before this happens, in our view it is wise to take advantage of rising yields. In our view most major fixed income markets are attractive at present. We would anticipate that credit spreads could rally further when it becomes clear that interest rate hikes have crested.
We saw a preview of this during the market rally after benign inflation readouts in December; the investors wise (or lucky) enough to correctly call rates’ peak stood to benefit greatly.
Underlying all this is the growing importance of fundamental credit analysis.
This focuses on opportunities, but there are always risks lurking to snare the unwary. Hedging strategies will remain key: there is no guarantee the shocks of 2022 are fully behind us, and every reason to believe they have heralded an age of persistent instability.
In the first quarter, for example, we saw stress in financials after both Silicon Valley Bank and Credit Suisse collapsed, leading to fears of contagion.
There are plenty of remaining inflationary forces that are unlikely to go away any time soon. This not only left us more convinced of the likelihood of a recession, which could put some pressure on credit spreads, but also led some managers to adopt a cautious stance with a defensive risk appetite, reducing portfolio risk and cutting higher risk areas of emerging market, high yield and subordinated debt in favour of developed market investment-grade corporates and focusing on issuers whose fundamentals they are more comfortable with.
Prior to the challenges faced in the banking sector in March, it had been a source of debate in our team as to why we had not seen more damage after one of the fastest periods of monetary tightening market participants had ever experienced.
The delayed impact of these policy shifts has finally revealed fragility under the surface, and we believe it is likely that more unexpected pockets of vulnerability will appear.
Potential expansion
Inflation is not yet a big enough political problem that any serious politician would propose cutting spending to stop it, and with both the US and UK starting to think about general elections in 2024, we do not think they have much appetite for inflicting pain on their populations.
This leads us to think leaders will again opt for fiscal expansion, which could create opportunities.
In our view, there will be credits that benefit from a historically rapid reflation, interest rate curves may get steeper, and countries that give money away too enthusiastically to their citizens may face interest rate premia.
The strongest conviction we have is that we are at the dawn of a new regime.Overall, while the recent stress in the banking sector spooked investors in the first quarter, the prompt intervention of central banks maintained financial stability.
While we believe these events brought the risk of recession forward, there are plenty of remaining inflationary forces that are unlikely to go away any time soon.
Therefore, we prefer to hold a moderate exposure to interest rates with four years of duration, as we believe that the path towards lower rates remains uncertain.
In a rapidly changing macro environment, remaining flexible and dynamic is paramount.
However, the strongest conviction we have is that we are at the dawn of a new regime, and that being a successful investor in the next 10 years may require a different set of skills compared to what was required over the past decade.
Long-term investors look at valuations through a 10 to 15-year lens and dig deeper into shifting behaviours and trends that drive financial markets, forgoing short-termism.
We believe that capturing the multiple market cycles ahead will lie at the heart of any successful strategy.
Colin Reedie is head of active strategies at Legal & General Investment Management
