Active Thinking

At GAM Investments’ latest Active Thinking forum David Dowsett discusses the implications of the continued inversion of the US Treasury curve, as well as the risks of lower liquidity, while Grégoire Mivelaz highlights the attractive value proposition offered by subordinated debt in terms of spreads, valuations and fundamentals.

30 November 2022

David Dowsett, Global Head of Investments

Over the past week, we have seen a continuation of constructive markets. As I look at valuations, I think most of the year end rally has probably now happened in terms of the levels that we have reached and in the very short term, we have some upcoming risk events that may introduce a little more volatility into the market. Federal Reserve Chairman Jerome Powell will be speaking later this week and the latest non-farm payroll numbers are due to be released on Friday 2 December. Therefore after a period of relatively quiet but upward markets, I would expect to see slightly more two-way risk in the short term from here, not changing the big picture but introducing a little more uncertainty.

One indicator that I think has been particularly noteworthy over the past 10 days or so is the continued inversion of the US Treasury curve, which is a very good indicator of a forthcoming recession. Across all market indicators, the US Treasury curve has the best forward-looking forecasting success rate historically and that is what the market is focusing on for 2023. This is not a bad thing for bond markets, but it is something risk markets will have to digest and to come to terms with as we move into next year.

At the present time, I do not think the protests currently occurring in China will lead to a huge overall change in policy response, or indeed any fundamental weakness in the Chinese Communist Party regime. We will, however, continue to monitor the situation as it evolves.

Finally, we are now in a period where liquidity is likely to be lower and that can bring its own risks. Investment banks have little interest in providing any inventory into year end given how challenging 2022 has been. As a result, we need to remain vigilant to outsized moves at a single security level, which at one level may seem unjustified when there is little news attached, but this is simply what can happen when investors do not want to make tight bid-offer prices.

In summary, I think markets will continue to consolidate and move up from October lows, but with a little more two-way directionality than we have had over the past couple of weeks.

Grégoire Mivelaz – Subordinated debt

Over the last six weeks, we have started to see a very good market for credit in general and we believe next year should be a strong year of recovery. Subordinated debt gives good visibility on income from strong issuers but is also subject to some price volatility depending on market conditions and that works both ways. While bonds have fallen this year, the underlying credit story remains unchanged, with no defaults or downgrades. To have a very good year, there must first be a bad year, which is what has happened in 2022, and so we believe 2023 could be a very good year. The price of bonds normally tends to recover after a shock within six to nine months. However, this was not the case in 2022 as there were a number of non-correlated shocks one after another, starting with the invasion of Ukraine, followed by higher-than-expected inflation figures, as well as the zero-Covid policy in China which put some pressure on the market. But all things being equal, we have started to see some normalisation in recent weeks.

While we believed 2022 would prove to be positive following the reopening of most economies following the Covid pandemic, it has been a very tough year. There were no hiding places as most asset classes were correlated, with few exceptions. The macro environment remains uncertain. We believe it is fair to assume that we are going to see a soft and mild recession in Europe. We might also see a recession in the US but that may be more of a story in the second half of next year. For bondholders, this means that investment grade (IG) should outperform high yield (HY) because, by definition, IG bonds are issued by strong companies with strong credit metrics. Issuers of subordinated debt are investment grade so naturally if we think IG should outperform HY, then that is a strong positive for subordinate debt. We believe inflation will remain high, but we should see a gradual fall in inflation in 2023 and 2024, back towards central bank targets. Nevertheless, the higher income captured, the better protected a portfolio is. Capital preservation starts by capturing an income above inflation. We believe rates will remain volatile but not as volatile as they have been this year and this should lead to some spread tightening. We believe that all the stars are aligned and this is an exciting market for subordinated debt.

We believe European credit could outperform US credit as Europe does not have the same level of inflationary pressure. Two months ago, we were talking about the energy shock that could turn into a very ugly outlook for the first quarter of next year and contingency plans for energy rationing were being prepared. We now do not see this happening. On margin, we stand in a much stronger situation now than a few months ago. In terms of the recession risk, we believe we are heading towards a mild recession in Europe.

Regarding high yield credit, over the past few years, the European Central Bank has injected substantial liquidity into the market, meaning we have not seen defaults. Looking forward, the corporate sector may be impacted by higher funding costs as rates go up and if we see a recession, we might start to see default risk picking up. Subordinated debt from investment grade issuers has been capturing a yield to call higher than European high yield in some cases, as well as offering better credit quality, higher price appreciation and less interest rate sensitivity as it is issued by the financial sector which is benefiting from rising interest rates.

In our view, the financial sector in Europe has never been as strong, considering asset quality, the liquidity ratio and the solvency ratio. Basel III, a framework that sets the international standards for bank capital adequacy, stress testing and liquidity requirements, strengthened the sector. This means that in the case of a recession and an increase in non-performing loans, which is part of the cyclicality of markets, banks can absorb the impact from earnings, as in a rising rate environment, there has been a pick up in the net interest margin and the sector also benefits from a strong solvency ratio.

The price of subordinated debt has declined by around 20% as spreads have widened. However, as soon as the market normalises, and we believe the catalysts needed for that to happen are in place, we expect spreads to start to tighten again. We believe that offers a good value proposition. If we are wrong and we have additional external shocks and prices do not recover as fast, we can afford to be patient given the high carry we are capturing.

As a result, we believe subordinated debts offers an attractive value proposition of wider spreads, better valuations and strong fundamentals.