December was to some extent a repeat of the themes dominating much of 2022. Equities sold off and bonds markets took a hit when both the Fed and the ECB again surprised on the hawkish side. That said, the relative development in fixed income market were markedly different. The Euro Aggregate Bond Index and the associated investable instruments like ETF declined by around 3% in December and finished the year more than 17% down. In contrast, US high grade bonds did relatively well through December and high yield bonds did relatively well in both USD and Euro.
The ECB press conference set the tone for the sell off, then in the last days of the year several ECB members told the world that a lot more needs to be done in terms of tightening. Such forecasts are fraught with uncertainty and this uncertainty is what markets must absorb at least in the first half of 2023. That said, both French, German and EMU aggregate inflation data released in early January showed significant declines and are probably signalling a turning point in headline inflation. This is making it less obvious that the ECB will have to remain as hawkish as recently communicated. The sell-off in bonds in 2022 implies that we are now looking at a significantly improved long tern return outlook as reflected in what one can plausibly expect to realise of return over the coming one to two business cycles. For example, in the first part of 2022 inflation adjusted real interest rates in the US moved into positive territory. Such positive rates have also arrived in the Euro market, where on the 30th of December 2022 the yield on the 10-year French government bond hit a 10-year high of 3.09%. Looking at the current market conditions, we note that while financial conditions tightened through 2022, the momentum has turned and they have eased recently as the USD has stopped appreciating, USD government bonds yields have stopped increasing, high yield spreads declined, and US mortgage rates have moderated. For the easing in financial conditions to be sustainable the Fed is likely to require an easing on wage pressure. In this context it is very positive that the most recent data show a decline in hourly earnings growth and recent revisions indicate this is a gradual trend in place for several months.
Figure 1: Government bond yields across the US and the Eurozone
Over recent years Chinese policy has not been kind to the entrepreneurial spirit and growth. That said, recent developments have been positive for the cyclical outlook. As macro data has shown weakness, policy has been eased. Following the initiated bail out of the Chinese real estate sector, more measures have been published in late December and early January. The most important development is probably the U-turn on Covid policy. The liberalisation and cancellation of travel restrictions was expected but it happened earlier and faster than expected. The Chinese economy now looks set for a cyclical rebound into 2023. With the global economic slowdown increasingly apparent and to a large extent priced across the US, Europe, and Chinese markets, we maintain our positive view of the cyclical development and a preference for equities. Within fixed income our uncertainty about the peak level and timing of the Fed and the ECB leads us to a preference for shorter duration and higher yielding bonds:
In our dynamic allocation strategies, with up to 100% equities, we hold equity allocations of 80 -100%. With corresponding underweights in high grade bonds.
In our balanced multi-asset strategies, we hold equity allocations to levels between 50% and 70% and we have maintained significant holdings of high yield bonds where yields remain close to and often above 7%, while BB rated bonds account for more than 50% of such positions.
Across our Global Fixed Income Opportunities portfolios, we have significantly increased high yield positions and we nota that across both Euro and US high yield we see unusually strong credit ratings with more than 60% BB rated bonds in the instruments we hold.
U-turns and tuning points
Over recent months a few significant turnings points have bene reached and we have even seen a genuine U-turn from the. Before we go through the man elements of these important development, we want to round of 2022 and start 2023 with a few lessons learned or often re-learned in 2022 and of importance for 2023 and beyond:
- Wars happen and they are often more unpredictable and more terrible than even those who start them expect. Putin’s quick invasion of Ukraine is now an ongoing embarrassment to him, his Chinese partners and the string of German Chancellors claiming to create peace via gas import and manufacturing export. We assuming continued funding of the Ukrainian efforts to save their country and the honour of the liberal west and see the main question in Europe as being if Germany and France can find a way forward playing a leading role or they will maintain their current wavering approach appearing secondary to the UK, Poland and Turkey? In any case the unpredictable of the conflict means that one should try to invest in a way not dependent on short term military outcomes.
- Inflation was under control for decades and right until central banks started looking for a bigger purpose in social justice. As money was printed, inflation roared back and became a serious issue especially for the poor and for financial markets. Central banks as institutions have re-learned the lesson, but we fear the short-term self-serving interests of the management at the Fed and ECB will lead to a tightening which is only optimal for a reputational risk management of these institutions. The world would be well served by a more experienced and non-political set of central banks, but the key lesson is unfortunately that we cannot assume that this will be the outcome.
Starting out from the side of what has not yet turned positive, we note that both the Fed and the ECB should be expected to continue tightening in the coming months and the peak of rates should only be expected in Q2 or Q3 2023. Most recently the limited rational for this is signalled by the weakness in business confidence across the world and not least in PMI`s in the US and China, which always spill over to the EMU economy. On aggregate the production side of the global economy thus seems to be in contraction. Such contractions carry the risk of initiating a negative spiral with declining revenue, increasing financing costs, increasing credit spreads, declining profits and ultimately for the most leveraged companies increasing default risk. Most countries and market don’t have the data necessary to analyse such development on market level and in approximate real time. The exception is the US where data for expected and actual earnings for S&P 500 are available through the I/B/E/S data, which now shows that profit for the Q4 2022 earning season should be expected to come out with a decline year over year of a couple of percentage. This currently expected to be followed by a small growth in Q1 2023 and a marginal decline in Q2 2023. In our view a more likely path and one investor should prepare for, is to see earnings decline by 10% year over year in the first two quarter of this year. Such an earnings recession is a threat to corporate finances, but the fact is that both high yield and high-grade credit spreads have contracted in recent months.
Figure 2: US business confidence indicates that global production is heading for a contraction
Part of the reason for the calmness seen in credit markets is probably a combination of the increasing probability of a soft landing or limited recession in the US and the significant improvement in credit quality in the high yield space. As mentioned last month, the share of US high yield bonds rated BB (the highest rating category in HY) bottomed at 35% before the Great Financial Crisis and has since increased to above 50%. In many liquid ETFs this number is above 60% and in some cases as high as 75% for (for example for the EHYA ETF from iShares).
In a world of excess demand, high inflation, and panicking central banks that the collapse of Chinese growth in 2022 helped in the sense that is helped inflation come down in the rest of the world in late 2022 and early 2023. In this way Xi and his advisors helped pushing western central banks away from the absolute panic point. Now the slowdown in China has run long enough, and probably too long for any anyone’s comfort. Both China and the world therefore stands to gain from the recent turn around in economic policy and toning down of nationalistic rhetoric’s most recently seen in communication from the new minister of foreign affairs. Qin Gang went as far a writing an article in The Washington Post praising America and Americans. While this was in connection with his transfer from the job as ambassador to the US to the broader role as foreign minister, it is still an extraordinary gesture and something one can assume was sanctioned from the highest place in Beijing.
The elimination of covid restrictions represents a genuine U-turn on a key policy area and as it is of both practical and symbolic importance, is probably represents the most important news in recent months. In addition, to his highly practical policy change also other areas have seen significant progress:
- Across the economy, lending standards and have been eased across the economy, reference rates have been reduced and credit have been made available with lending quota increases the latest positive news.
- The clamp down on the construction sector has been reversed and in many cases winners and losers have been identified (or chosen by policy makers) and the easing in lending standards and landing rates in this area represents one of the most important stimuli to the economy.
- The announcement that Jack Ma will give up his special voting rights and thereby his special influence on Ant financial, probably signifies the turning point in the multi-year war the communist party has waged against the Chinese technology sector. From an economic growth point of view this clamp down on e-commerce, e-education and gaming was counterproductive and the turnaround should be a positive for growth.
- From an ideological and political point of view the clampdown was even more important. The issue was that enormous wealth was being created in these companies, creating the impression that capitalism and individual wealth was glories. Many of these later giants were co-funded by western venture capital which is a poor fit for the ideology of the Chinese Communist party. In addition to this many of the holding structures were based on foreign companies with legal structures which had never been accepted, let alone encouraged in mainland Chinas legal system. By fighting theses technology power houses, Xi could both win the ideological battle against the abnormal wealth creation and take down some of the most prominent new stars in the Chinese society.
It is too early to assess if the changes implemented in the recent months and weeks merely represent a tuning-points in a cyclical context or a more pronounced U-turn in Chinese policy. For our part we remain sceptical about the policy sensitive areas and maintain that the easing of retractions is as much driven by the necessity of getting the economy started again as by a desire to see capitalism flourish again. That said, for now, the changes are probably large enough to be cyclically helpful on a scale which is significant for both global growth and global markets. As such they also support our positive view on equities.
The view laid out on the preceding pages is reflected in our algorithms. The dramatic recovery in emerging market in general in Chinese and Hong Kong equities, seen in figure 3 on the following page, is helping to stabilize our market algorithms at positive levels. At the same time the stabilisation of government bonds yields and the decline in credit spreads have resulted I a renewed positive signal from our credit algorithms which now signal a positive momentum in the credit supply and conditions for both IG and HY companies. This observation is supported by a surge in corporate bonds issuance in the first week of the year. While the issuance amounts in the first week of the year were slightly below level seen in the first week of 2021, the development is still very positive as it comes after very low issuance in the last weeks and months of 2022.
Figure 3: Chinese and EM equities have rallied but are lacking US equities on a 5-year horizon
Mads N. S. Pedersen
Managing Partner and CIO