Written by Arif Husain, head of international fixed income at T. Rowe Price
I have travelled around the world meeting issuers, strategists, and clients a lot this year. Most people agreed with me that the world has changed. But then I ask them, what have you done about it? How have you responded to a change in markets, a change in volatility, a change in the way we all work and live? And the answer is usually very little. Investors must think and act differently in 2023 and beyond.
It has been volatility that has led us to this limbo. So, let’s look at this. Volatility starts with central banks in my view. Post-global financial crisis, we used to get central bank statements with maybe one change of word, and while everyone analysed this one change of word, I never used to feel much changed.
Following this, we went from a period of ‘we are not even thinking about thinking about raising rates’, to ‘is it going to be 75 or 100 basis points?’ Massive central bank volatility leads to massive rate volatility, which then leads to massive curve volatility, and credit volatility. This then feeds through to equity markets. This is the way I think those concentric circles of volatility flow through. For an active manager, volatility is not something to fear, it is something that produces great opportunities, and this is certainly something we are going to be embracing.
For us, as the concentric circles move through, volatility is certainly elevated. One of our concerns is there is an additional impact from volatility on liquidity. Just as we have gone through quantitative easing into quantitative tightening, there has been a structural change in the world that has led to higher inflation. The key thing for investors to note is that market structure is fundamentally different now, and market structure is something investors do not spend enough time thinking about.
The moves from active management to passive, and from public markets to private, have fundamentally changed in how people invest. This is not active versus passive or public versus private debate, it is just a matter of fact. The changes have had a massive impact on market liquidity, which has created a feedback process that develops into further volatility, which then feeds back into liquidity again. In my mind, credit markets are at risk because the liquidity premium that is priced in is still not sufficient for the reality of public markets today.
The illiquidity of markets is something we all need to deal with. We are probably at a point over the next few months where we are going to find out the outcome of this. Using fixed income terminology, we are probably at the point of maximum convexity. This means we are in an unstable equilibrium. Something must happen. We are either going to get a meltdown in credit markets like in 2008, or we get big, big rally. While market performance in Q4 so far looks like the latter, looking at liquidity and the quantitative tightening situation, it could still look like 2008.
Ultimately, investors all end up becoming asset allocators. We all want to put different assets together to end up with a better combination. The important thing to remember, is that the best players do not necessarily make the best team. Doing nothing though? Think back to the returns in fixed income assets in 2022. It is a very dangerous, and conscious decision.