Market participants should buckle up and brace for further turbulence. Since the dip in October, they have generously benefited from the recovery in late autumn and winter, as the spectre of stagflation had vanished, at least for a short period of time. This mood swing was triggered by the positive combination of mild weather in Europe, which prevented an energy crisis, and the end of China’s zero-Covid policy, which fired up growth prospects in Europe. In addition, inflation data published during the fourth quarter indicated that central banks have the upper hand in the battle for price stability. However, market sentiment has been cooling rapidly since February, as recent releases show that the price development is still too strong. An overheated labour market coupled with rock-solid consumption are giving central banks the economic leeway to tighten monetary policy even more, despite the fact that it has already been ratcheted up at record-breaking pace.
The cumulative increase in US interest rates by 4.5 percentage points in less than a year is a bitter pill to swallow, not just for inflation but also for the markets. But, as with any cure, there is a time lag before it takes effect. Inflation data for January, which were published in February, exceeded expectations by such a wide margin that the question must be asked as to whether monetary policy is still much too loose. “Long and variable lags” in the effect of monetary or fiscal policy hugely complicated matters for decision makers. In addition, much of the data published in February included technical factors, such as seasonal adjustments, which contributed to the surprise. It is therefore particularly important not to lose sight of the big picture. The end of the cycle is a bumpy ride, but opportunities abound.
How can investors survive the turbulence as unscathed as possible?
The taking of greater risks was rewarded during the Goldilocks period of recent months: segments with comparatively high-risk sensitivity – such as emerging markets and high yield, but also cyclical sectors – delivered a distinct outperformance. This period of “easy money” is coming to an end because volatility is increasing again due to the uncertainty over monetary policy. Using the metaphor of medical treatment again, we would describe the current situation as one where the medicine has not fully developed its impact on the patient yet. Administering the medicine at higher doses just because the patient’s symptoms have not yet fully disappeared entails serious risks. If we apply this logic to current markets, the ensuing over-tightening could cause buyers to boycott riskier assets. At the same time, increasing interest in the kinds of assets that are defensive or tend to be safer would return the focus to quality. Particularly if a recession materialises, but also in the case of a further distinct economic slowdown, we see investment grade (IG) issuers as having a clear advantage over their high yield (HY) counterparts. This is because HY issuers are more sensitive to economic stress than IG issuers since their profit margins provide less of a buffer against rising cost pressure potentially leading to higher default risk. However, the risk premia offered by the HY segment have fallen to such low levels, owing to the bear market rally of recent months, that it is possible to switch to the higher quality IG segment at a comparatively low opportunity cost. On top of that, many large-scale investors, such as pension funds and life insurance providers are still underweight the IG segment following years of extremely low yields, which should provide technical support to the market. With the yield curve inverted, we expect demand for bonds with short to medium maturities to increase. Of course, this raises the question as to whether money market products are the more attractive option at the moment. If the investment horizon is a few months, these short-term investments offer decent income and are likely to have a rightful place in the portfolio. However, this strategy would expose investors with a long-term horizon to reinvestment risk, and they would hardly benefit at all once the over-tightening finally leads to lower interest rates for medium maturities.
In terms of the combination of bond currency and issuers, we currently still prefer EUR to USD bonds, as net of currency hedging costs the USD yields are lower than EUR yields of comparable instruments. A sweet spot we have identified is EUR bonds from US issuers (so-called Reverse Yankees), as they currently provide the best of both worlds – solid fundamentals and, at the same time, attractive risk premia.
Since the fourth quarter, however, a shift has been taking place on this front: first, EUR bonds have recovered to a greater extent in the past few months, which has narrowed the yield advantage. Second, the USD currency hedging costs for investors in the euro area are falling sharply (hedging costs based on forwards fell from 3.2% in October to 2.1% at the end of February). The reason for this development is the monetary policy convergence between the Fed and the ECB. We expect that the EUR sovereign bond curve will invert much further, as the ECB, we believe, must tighten its monetary policy more aggressively to combat inflation. This is likely to reduce USD hedging costs further, which could eliminate the yield advantage that EUR bonds hold over USD bonds in a matter of months and ultimately lead to price pressure on EUR bonds. Developments on this front should be closely observed in order to calibrate the portfolio positioning gradually to the altered reality.
In the longer term, too, we see potential for IG corporates to deliver an attractive performance. Even if we continue to witness some volatility in interest rates in the next few months, we believe in the effectiveness of monetary tightening, which is already showing in leading indicators and in corporate earnings. We therefore expect a sharper slowdown in the second half of the year, which means that the policy tightening needs reconsidering. In this eventuality, high-quality bonds are then likely to benefit from falling interest rates, while selling pressure is likely to remain on lower-rated bonds due to their fundamental risks. It should therefore be worth weathering the turbulence with a positioning that offers sufficient shock-absorbing properties as well as potential for recovery.