Written by Fabiana Fedeli, Chief Investment Officer, Equities, Multi Asset and Sustainability
I had planned to start this Quarterly with a dive into the impact of ‘higher for longer’ and the odds of a recession. However, something more pressing needs to be acknowledged. The new quarter has begun with horrifying images from the Middle East. Our thoughts go out to those affected by such senseless violence.
As abhorrent as the recent events have been, financial markets, for now, have taken them in their stride. There has been some flight to safety in public markets with treasury yields declining, but overall markets have had fairly mild reactions, with many regional equity markets concluding the week following the start of the violence slightly higher..
Judging from their behaviour, investors appear to have taken the view that the events in Israel and Gaza are contained and there is no broader contagion. Should that change, the most likely and immediate impact could come from a declared or assumed involvement of Iran that could lead to a tightening of oil export sanctions. While there seem to be different estimates in the media, JP Morgan puts Iranian exports at 1.7mnb/d1. M&G Investments’ Equity Research team believes that any decline in supply would have to be met mostly by Saudi Arabia. In our opinion, Saudi Arabia wants a higher oil price but not at the level of creating demand destruction and dragging the world into a recession. Hence, the country would be likely to reverse the most recent cuts and possibly add. That said, the current supply/demand situation is already tight, and we should expect oil prices to rise further. As of the time of writing, we have not seen any steps toward further Iranian oil sanctions but – as we know – the situation can change quickly.
While the Middle East is – rightly so – capturing our thoughts and news headlines, markets remain focused on a different topic. A quick check of Bloomberg’s News Trends story count shows how topics such as recession and inflation, after peaking in the second half of 2022, are now back to early 2022 levels. The topic that is proving increasingly popular, unsurprisingly, is ‘higher for longer’.
Investors’ realisation that ‘higher for longer’ interest rates are more of a reality than they previously thought is the most likely driver behind the declines that we have seen in most asset classes over August and September.
Pause, if not a stop
After having witnessed declines in the US, core inflation has also started to decline in the UK and in the Eurozone. It is, however, still high compared to central banks’ targets, whether you believe that they are set in stone at 2% or somewhere under 3%. The big change has been the rapid rise in yields at the long end of the yield curve across both developed and emerging markets. The higher yields may be doing some of the tightening work for the Fed, the Bank of England (BoE) and the European Central Bank (ECB), and a pause from central bankers to monitor the impact of previous hikes on the economy is increasingly likely. Given the more rapid decline in US core inflation, the Fed may be the closest to the end of its rate hike cycle, with a declining chance of another rise, and most likely not, at the November meeting. That said, until either inflation moves closer to target or we see a very pronounced slowdown, central bank rates are unlikely to be cut to a level that would make markets more comfortable.
The elusive recession
Our investment teams meet regularly to discuss markets, each from the point of view of their different investment universes. One of the most heavily debated topics is that of the ‘elusive recession’; or one that has been announced many times over the last year, but has yet to arrive. Indeed, the macroeconomic backdrop is proving more resilient than many had expected, particularly in the US. There is a valid explanation. The higher interest rates have not affected many consumers and corporates yet. In the US, many households are paying fixed long-term mortgage rates (unlike many UK households) and companies with longer refinancing schedules have yet to pay higher rates on their debt. That said, data from the Federal Reserve (the Fed) indicates that the pre-pandemic excess savings of US households are expected to be depleted in 2023. At the same time, student loans become repayable from October, although for another 12 months borrowers will be able to miss payments without being reported as delinquent. Revolving card balances have also been increasing. Nothing is alarming at the moment, but we will need to monitor where we go from here, as most datapoints lead to future erosion of disposable income.
Importantly, this data hides large differences between the lower and higher income demographics. Companies that we speak with have pointed out that, in the US, the former may have already depleted excess savings, while the latter may still have a buffer well into next year. We are also seeing large differences between subprime and prime customer bases when it comes to unsecured provisions at credit card lenders; where prime has risen from the pandemic level lows but is still below 2019 levels, and subprime appears above.
And, while the topic of recession does not appear to be front of mind in the news flow – and current macroeconomic data doesn’t show signs of a deep recession or a widespread credit crisis looming in the near term – expectations of further demand contraction appear logical. Consumers and corporates will have to face higher financing costs, which is likely to affect their spending power.
And if a recession were to come, there are different degrees of severity, and risk markets could remain resilient in a mild recession. Let’s not forget the German Dax Index (the Dax) was up in the first half of 2023 despite the country having entered a technical recession, given a quarter-on-quarter GDP decline of 0.5% in the fourth quarter of 2022 and a 0.3% decline in the first quarter of 2023. Incidentally, the Dax is still up year to date, despite having lost ground with many other equity markets in August and September. In our previous Quarterly Equities and Multi Asset Outlook, we acknowledged that we had seen some weak macroeconomic readings across the globe, and some datapoints further weakening. However, others had remained resilient and there still was no sign of an imminent and pervasive collapse in global demand. Given the lack of visibility on the demand outlook in the near term, with a wide range of possible positive-to-negative outcomes, we stated that it was too early to throw in the towel on risk assets. Since then, from a macroeconomic standpoint, growth has remained feeble but has not collapsed.
More cautious
With real rates now in positive territory even in the US, equity risk premia have risen, putting pressure on equity markets. This could continue for a while, and, although we still see pockets of future positive performance in equities, we have turned more cautious on the overall equity market in the near term. Our Tactical Allocation Multi Asset strategies have reduced wider equity market exposure and added to fixed income.
We find the long end of the developed sovereign bond markets (including US, UK and German 10- and 30-year government debt) more attractive following the recent price sell off. It is always difficult to find the perfect entry point in the midst of market volatility. That said, with the Fed closer to the end of its hiking cycle, historically this has been a precursor of peak rates at the long end of the curve. The long end of the curve also serves as an ‘insurance’ should a macroeconomic slowdown ahead be more significant than the market expects.
To be clear, we are not running for the exit in equity markets. We still find attractive pockets (a gift that we often get from fearful markets) but selection remains key. Given the uncertain macroeconomic backdrop, in equities we prefer investments where structural drivers are stronger than cyclical exposure. We remain selective and high on the quality spectrum. We invest in companies with strong moats, pricing power, balance sheets and cashflow generation. We continue to favour structural long-term themes that should prevail, independent of near-term volatility; infrastructure, the low-carbon ecosystem and innovation, including AI.
Importantly, we still don’t believe this is the time to buy broad markets. As companies deal with a high interest rate (and a positive real rate) environment, weak demand, and relentless innovation, there will continue to be winners and losers. We think less and less in terms of buying whole sectors or countries. We need to go one layer deeper. This will appear very clear from our desks’ insights on how they are navigating current markets..
Seeking opportunities when markets are fearful
One change that we have witnessed in the August and September equity market sell off, is that after three years of equity return dispersion running above its 10-year median, we have seen a compression in performance differential. This, in our opinion, offers us a fresh opportunity to harvest alpha from selection.
In particular, we see a timely prospect to add to the infrastructure space as the fears of ‘higher for longer’ have brought companies in the utilities and real estate space to multi-year valuation lows. For a number of these companies it is a case of the ‘baby being thrown out with the bathwater’ in the panic around so-called ‘bond proxies’. However, many of these companies have solid balance sheets, with fixed rate debt, long-term maturities, cost pass-through in their pricing agreements, and many pay attractive dividends. As always, selection is key.
One final thought on a market that investors seem to have forgotten after years of low interest rates: Convertibles. Over the past fifteen years, lower rates meant that corporates could find attractive funding in straight bonds. Higher financing costs and looming debt maturities in 2025-26 across all types of issuers should force corporates to issue new debt and contemplate convertible bonds (CBs) as a cheaper alternative to straight bonds.
Given the vastly larger size of the corporate debt market versus the convertibles market, it could mean additional CB issuance equivalent to the typical one year run rate. This should offer more opportunities, particularly higher on the quality scale, as investors will have a wider choice of issuers to select from.
We wish you a strong fourth quarter and a good close to 2023.
