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Looking beyond the short-term uncertainty to identify potentially rewarding opportunities for the agile and discerning investor in 2022.
Assessing the impact of COVID on the economy is a complex task. Many forces are at work and are impacting economies around the world: shutdowns, re-openings, demand pattern changes, supply disruptions, fiscal and monetary stimulus, etc. The magnitude of some of these phenomena is significantly greater than in decades prior to COVID. As a result, the economy as a dynamic system is unlikely to behave according to familiar patterns. Economic models are not calibrated to the current environment and to second-order effects that could otherwise be ignored but could lead to unexpected outcomes. We see changes in labour supply that are difficult to explain, inflation is influenced by additional forces that make it more resilient for the time being, etc. This makes forecasting economic variables very hard, leading to larger deviations in estimates and therefore, to bigger surprises (to the up and downside) and more volatility.
In developed markets for example, this phenomenon has been visible since October when the Bank of England and the Reserve Bank of Australia caught the market off-guard and added significantly to volatility. The same happened more recently when Fed Chair Powell changed tack on the use of ‘temporary’ to describe inflation. Central banks and the investor community are looking at similar data and are likely to be equally at a loss.
Our key message here is that it is difficult to do short-term forecasting. Instead, we should focus on the overall direction seemingly taken by the various forces driving the rate markets :
The long-term inflation dynamic has not fundamentally changed. Most long-term drivers of inflation remain intact (even the extra fiscal stimulus should normalize over the longer term). We therefore expect inflation to normalise, and in fact at some point, base effects will start kicking in as some prices normalise, leading to negative contributions from these components of the basket.
Similarly, potential growth is unlikely to be fundamentally different from what it was pre-COVID (any productivity enhancement will be offset by lower labour participation and aging dynamics). Growth is also bound to ‘normalise’ back to pre-COVID levels.
Therefore, central banks are unlikely to be able to hike as much as in previous cycles. The long end of the bond market is saying as much, as it did not sell off when the shorter end was pricing in more hikes earlier this quarter. On the back of momentous, still increasing, government debt, in combination with an ageing society where productivity is not improving significantly, any hike in interest rates would have a heavier-than-usual tightening effect. This will limit the scope of the upcoming hiking cycle. We see the current number of hikes priced in as reasonable. The Fed is unlikely to reach its final dot-plot of 2.5% for the policy rates. If anything, we would see rising rates as a buying opportunity. A couple of caveats though. Clearly, the COVID-induced volatility could be exacerbated by a number simmering geopolitical issues like Ukraine, US-China relations, etc., although that is not our base case. Another volatility-enhancing scenario is if inflation is truly more persistent, staying elevated for a significantly longer period. In such a situation, central banks would have to act a lot more aggressively.
Elsewhere, in emerging markets (EM), the real yields on government bonds are very attractive. In addition, their spread over US Treasuries is quite generous, even compared to the 2013 taper levels. So EM rates are starting to look enticing. However, despite multiple policy rate hikes in many EM, the real policy rate is still negative because of high inflation. Once inflation starts to normalise, the increasing real policy rates should support currencies, which would make the FX component more attractive. Therefore, we still want to wait a bit and go overweight later in 2022 once we deem valuations even more alluring.
Credit spreads are likely to be less affected than rates by the current volatility, although they are not immunized against it. We expect investment grade (IG) credit to remain supported by several factors. First, we expect an extension of the ECB bond-buying program, although its pace would be more limited. Second, real-money end-investors have been strong buyers and are expected to remain so, as corporate IG credit still offers a reasonable spread over government bonds. Finally, many companies have significant cash buffers and are therefore less likely to go into record-breaking issuance next year. We have a neutral stance on IG credit. In case of significant widening, we could envisage going overweight, with care.
Similarly, high yield spreads are well supported, but could record some widening in the case of continuous volatility. Again, there are multiple factors at play: companies have deleveraged and hold significant cash reserves. In addition, the ‘maturity wall’ has been extended to 2023. An important risk is that some high yield companies will use some of their cash pile for M&A, extra dividends or share buy-backs. This equity-holder-friendly behaviour could put spreads under pressure. However, such behaviour is more typical of CCC companies and we remain prudent on that category.
From this point of view, convertible bonds are almost the mirror image of high yield bonds. The shareholder-friendly behaviour would benefit the equity upside built in convertible bonds. One caveat to have in mind for convertibles is their peculiar sector allocation (given for example the limited number of issuers from the banking, insurance, or materials sectors). As the equity upside doesn’t always translate directly into an upside for convertibles, we remain neutral on the asset class for the moment.
Finally, we’d like to draw attention to the rapid growing universe of sustainable debt securities. Mounting awareness of the need to support environmental, social and governance excellence has driven investor demand and regulatory changes. This, in turn, has led to record issuance of “green” debt by an ever-wider pool of governments and corporations. Diversification opportunities in terms of issuer type, credit rating, geography, sustainability type (green bond, social bond, etc.) abound and we expect 2022 issuance to increase further. Amid this greater expanse of choice, DPAM’s time-tested ESG and fundamental analytical processes as well as its active bond selection style will prove invaluable as we usher in a new year that, undoubtedly, will hold its number of surprises.