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Current pricing patterns across asset classes in markets resemble the Shibuya Crossing in Tokyo city. As a visitor, when getting out of Shibuya Station Hachiko, one is confronted with a sea of traffic lights. The moment lights switch red cars and buses clear, and a flood of pedestrians inundate the crossing. People stroll in all directions. It is the metaphor par excellence as some market participants discerning green lights, after staring at a fierce and fast market correction from the side, get moving. Most move with care through rebalancing or putting cash at work in bond markets. Bond markets that offer correct long-term returns. Large cohorts of investors do not trust the environment at all and opt to remain on the sidelines. The inflation psychology that spreads has infiltrated the minds of market agents and blocks decision-making.
Asset owners and managers are called to reposition based on their assessments on the path of inflation, growth, employment and demand-supply relationships. H2 2022 is ahead of us and damage has to be mended. Shell-shock behaviour or immobility will not lead to better outcomes. The more cash is deployed, the faster consolidation and calm can set in. Implied volatility might dampen as US policy rates get to 2.25%-2.50%…Remember that this level was called a terminal rate not that long ago. As soon as the FED is over halfway into the hiking cycle, market psychology might change for the better.
The valuation reset over the past 6 months pushed expected returns towards levels not witnessed since 2014. Consensus is broadening that real growth across US and EU will fall well below potential. US real growth will average about +1.00% over 2022 and 2023. EU growth is predicted to crumble towards 0.00% over that horizon. The probability of a European recession, given the energy and confidence shock, surpasses US recession odds.
A tentative supportive signal came through as a negative bond-equity return correlation gained strength. With the Fed president reconfirming an inflation-only focus last week, inflation expectations took a hit and bond prices rallied pushing long rates lower. The attention of equity and credit markets is squarely on the growth path. The end of week rally in equity was an expression of end of quarter rebalancing flows. Calling it a bottom or the start of a consolidation pattern would be premature. As the ECB will join other DM central banks in kicking-off its tightening cycle on July 21 quickly followed by another 75bp FED hike on July 27, expect markets to remain nervous. The June 30 US core PCE deflator (consensus at +4.8%), the July 8 US employment figures (consensus on a +275k number) and the July 13 US CPI print (previous upside surprise read +8.6%) are key data points that will colour the summer months. In the meantime…
Value propositions across US, EU and Emerging-Market fixed-income sectors display attractive readings. We define ‘attractive readings’ as offering real return value corrected for inflation expectations over 5, 10 up to 30 years. Depending on the risk profile across rates and credit, we look at the following expected return ranges. In US and EU rate markets, we climbed towards a 3% to 3.5% range in Treasuries against 2.50%-2.75% for European government bonds. Investment grade credit spreads have climbed rather aggressively over the first half of the year. Indeed, European quality corporate bonds boast spreads above 200bp, and active investors can obtain expected returns in a 3.25%-3.75% range without undue risk-taking. Within US IG credit, with the BBB 10-year credit spread at 215bp, returns between 5% and 5.5% can be constructed. Such outcomes do somehow come with longer duration exposure in comparison to EU IG credit. In European high yield, we reached spread levels close to the upper bound of 600bp that featured in the ‘The High Yield Barometer’ piece a couple of weeks ago. At a spread of 582bp to government and a yield to worst of 7.01%, we have landed in territory that releases systemic risk perfumes. US high yield valued at a spread of 528bp to government, offers a yield to worst of 8.45%. Writing these numbers down brings perspective but also hope that the worst of the bond correction is behind us. Enter emerging market government bond markets. The JP Morgan GBI-EM index yields 7.00%. Yet, active managers can obtain an 8%+ yield again without high-risk intensity. Yes, carry is back. Momentum has left the scene as central banks turned the QE corner and are on a one-way hiking avenue. Bond markets, that accrue on carry, send an invitation to investors to become patient. Patience that got lost over the previous decade. High carry also comes with higher protection levels over a 1-year horizon. If we take a portfolio yield of 5% on a duration of 5 years the capital of investors is preserved, protected even if confronted with a rise of 100bp in rates and/or credit spreads over a one-year horizon. End-of-last-year bond portfolios had almost no carry. Today’s harsh outcomes are testament to that.
If we return to the Shibuya crossing. Looking at the frantic crossroads, one expects accidents to occur. However, these are rare. Again, with financial conditions getting tighter by the month, investors expect more defaults, more casualties through share price air pockets, more of everything that is bad. However, the past two and a half years we – all market actors, including central banks – were victim of overshooting behaviour. That has led to overshooting in outcomes. Outcomes that are difficult to qualify. Has the rerating altered the resilience of companies or governments? For sure we learned that modelling under chaos is complex to impossible.
Inflation has run havoc in valuations in a blink of an eye (or the time it takes traffic lights to flip from green to red and back). The rules of the game have remained the same. Time to reflect and purchase value where value is due and visible over an appropriate investment horizon.