CIO views: ideas for ‘back-to-school’ returns

Asian fixed income: a low-turnover approach favouring financials and India

Asian and emerging market (EM), USD-denominated credit markets have witnessed a weak summer owing to the sustained level of Treasury yields and a double-dip in China’s growth. The greater US fiscal deficit means that the US will now be borrowing more than USD 1 trillion versus last year, increasing Treasury bond sales. This firmed 10-year Treasury yields from 3.4% in May to 3.8% to July, and as high as 4.3% in August. 

China, on the other hand, has witnessed weaker-than-expected growth since the second quarter, reducing exports to developed markets (DM), retail spending, domestic consumption and property sales. These factors led to higher yields across the Asian and EM USD credit universe, amid lacklustre summer markets with thin liquidity. 
 
Yields now look high, in our opinion, and in an unstable, long-term equilibrium against a backdrop of US headline CPI falling from a peak of 9% in mid-2022 to 3.2% currently, and US employment growth slowing considerably since June. We expect US headline CPI to drop below 3% by early 2024, and for DM growth to be around just 1% in 2024. Meanwhile, China is releasing its next batch of stimulus to shore up credit growth and spending in the economy, to achieve 4-5% GDP growth. We expect this to stem the weakness in Chinese asset prices, as well as the surrounding region.

We envisage liquidity will return to Asian and EM bond markets in September, and that credit valuations will tighten a little. Within investment grade, we favour the financial sector, where many regional banks are posting record profits, and we expect credit spreads across the capital structure to compress in the coming two quarters. From a country perspective, we are seeing significant global capital flow into opportunities in India: this remains the largest country allocation across most of our credit funds, especially in the BBB and BB rated segments, and particularly in renewable energy and infrastructure sectors. 

Generally, as yields are at around record highs, we continue to be patient investors here with low turnover. 


 

Equities: eyes on the yield curve 

We see three unusual dynamics characterising equity markets at present:

1. Year-to-date returns have been extraordinarily concentrated, with seven mega-cap companies generating about 60% of the MSCI World Index’s performance²  
2. The small- and mid-cap (SMID) space is trading at a considerable discount to larger cap names, despite the historical trend of SMID caps outperforming larger companies in rising markets
3. The US Treasury yield curve is extremely inverted. This is unsustainable and a reversion is due at some point

In the coming months, a key question is: what will be the nature of the yield-curve normalisation, and how could this impact equity markets in the context of the other two dynamics?
 

Bull or bear steepening?
Yield curves usually normalise either through a ‘bull steepening’ or ‘bear steepening’. A bull steepening typically happens when central banks cut interest rates as a recession hits. These conditions tend to benefit bonds but not equities, as earnings per share (EPS) are often weakened by the downturn. A bear steepening happens when long-term rates rise as the economy enters a longer, maturing phase of an economic cycle. This is usually bearish for bonds but supportive for equities, as EPS growth can be sustained for some time. 
 

A rally beyond mega caps?
As the current cycle matures, the ongoing resilience of the US economy is increasing the likelihood of a bear steepening, in our view. 

Since the country represents about 70% of the global developed-market universe, stock-pickers should take note. Should a bear steepening take hold, supporting a broadening of the equity rally beyond the mega-cap companies, many conservatively priced firms could potentially re-rate higher. In this environment, we are focusing on financially robust, attractively valued companies that are exposed to structural growth opportunities.


Sources.

2. Source: Silvercrest, Bloomberg as at September 2023.

Convertible bonds: the case for semiconductors

There is still significant economic uncertainty in the United States, making short-term investment decisions challenging. Consensus expectations were for tighter monetary policy to slow economic activity significantly, raise unemployment and finally, cause a recession. Macro data releases, however, paint a much more resilient than expected picture, leaving many questions.

In the equity market, the main issue is what to do with cyclical and growth names? We are tactically increasing our allocation to a sector which ticks both boxes, has its own medium-term dynamics but remains very much aligned to the long-term secular trends of electrification, digitalisation and AI - semiconductors. 

We expect the semiconductor sector to continue to rebound from last year’s lows, mainly because we believe we are in a favourable part of the inventory cycle. Historically, peak inventories have been a reliable buy signal³. Inventory depletion will likely start in Q3 of this year. Prices should start to rise as inventories decrease in the second half, fuelling expectations of improving revenues and earnings, in our view. The positive share price momentum will likely end when inventory starts to rebuild, but this should be at least a few quarters away. We see memory as the best positioned segment, followed by semiconductors for mobile, PC and automobiles. 

From a tactical perspective, the risk is that weaker end-demand for consumer products (such as telephones and automobiles) could cause the sector to give back year-to-date gains. Overall, though, the secular tailwinds are still very much in place. Shortages in certain pockets of the market are an ongoing issue and, therefore, we believe the semiconductor sector could be positioned to perform when others disappoint.


Sources.

3. Past performance is not a reliable indicator of future returns.

Multi asset: promising signals in credit spreads, equities and commodities

The data fail to indicate the recession that market consensus had been expecting. Instead, US growth is picking up and, since the start of August, our indicators show the data is improving in the US. Even the inflation question is back: our inflation surprise indicators show a persistent signal of pressures building since May. We see less surprise potential from monetary policy, where only minor rate adjustments are expected in light of the policy already deployed.

The phase of the cycle is the subject of some debate. Still, if this is a late cycle period, such circumstances typically favour investing (temporarily) in reflation and in higher beta assets. And the next step is more likely to be a recession than an expansion, so let’s keep our finger on the trigger and be ready to buy bonds again. Just not now.

As systematic investors, we follow a disciplined, process-driven, risk-based investment approach. What are the signals telling us?

Sovereign bond valuations are undoubtedly more attractive, although yield curves are inverted, which nullifies one of the traditional positives of bond investing. Furthermore, bond volatility remains at extreme levels, and price dynamics are negative across all the main markets (US, Europe and Japan), bar China. 

Other asset classes display more promising signals. Credit spreads, equities and commodities have all seen their volatility normalise over the last few months. Price dynamics are more positive, too. After a volatile first half of the year, commodities benefit from strong momentum. We believe that all of these merit continued investment, and we currently run above-average allocations. Finally, risk management remains essential, in our view. 

Our positioning remains prudent, falling back also on cash to fine-tune our risk deployment and remain in line with our portfolios’ and our clients’ risk profiles. 

To read the full feature viewpoint, please click here.
 

Sustainability: drivers of the circular economy

In today's investment landscape, the interplay between long-term sustainability goals and the demand for short-term performance creates a nuanced challenge. Navigating this calls for a strategic approach that identifies opportunities aligning with both overarching trends and near-term performance objectives.

The circular economy stands out as a compelling avenue—a framework promoting resource efficiency and zero-waste practices. Companies embracing this model stand to gain from cost savings, operational resilience, and environmental stewardship, making it an attractive proposition for investors.

One primary driver lies in the creation of economic benefits. Embracing circular principles can lead to cost savings by optimising resource utilisation, reducing waste generation, and enhancing operational efficiency. Companies that adopt circular practices can experience streamlined production processes, lower raw material expenses, and minimised disposal costs, contributing to improved profit margins.

A second driver has been the inflationary pressures amplified by the search for alternative material sources. Circularity practices gain prominence as companies seek to secure supplies while managing costs. For example, by using lower-grade scraps or waste materials and enhancing efficiency in recycled formulations, companies can offset the rising costs of virgin materials. This dual-pronged approach addresses both resource concerns and cost volatility with traditional production methods.

A third driver is regulatory changes promoting the adoption of circular practices. Take the fashion industry, where the European Commission Extended Producer Responsibility (EPR) scheme seeks to enforce producers to be accountable for the entire lifecycle of their textiles, curbing waste, and its ecological impact. Companies that proactively integrate circularity gain a competitive edge over peers less prepared for this transition. 

Strategically positioning investments in circular economy champions can yield tangible returns as circularity practices often yield short-term cost savings and increased operational resiliency, potentially driving financial performance and shareholder value.
 

Alternatives: complacent markets provide fertile ground

In the second quarter of the year, markets rapidly settled into an environment that reminds us of previous periods of extreme complacency, such as in 2017. Some indicators of risk we monitor closely are effectively sitting at the bottom of historical ranges. In particular, US credit spreads and equity volatility indicate very sanguine markets, in our view. The low level of the VIX index, for example, seems to ignore almost completely the new regime of current interest rates. US credit spreads appear to price in next to nothing in terms of a potential economic recession. While our objective is not to predict the future, we can’t help noticing that these indicators seem out of line with reality.

In our alternative range of convex solutions, we aim to build portfolios with very asymmetric and uncorrelated return profiles. These types of solutions will generally perform more modestly in environments of depressed volatility and market complacency but have the potential to thrive in extremely volatile markets. In practice, the market conditions in place since the beginning of the year are an overall headwind for this franchise. However, complacent markets are generally a fertile ground to build defensive trades, which could do well during future episodes of volatility. 

As such, we see good entry points to build credit relative-value decompression trades as well as long volatility positions.