Active Thinking

At GAM Investments’ latest Active Thinking forum, David Dowsett and Richard Briggs discussed the difficult start to the year for both equities and fixed income, and opportunities in emerging market hard currency debt despite known headwinds.

03 May 2022

David Dowsett – Global Head of Investments

Taking Stock

2022 has so far been an extremely traumatic year for financial markets. Global equity indices are down over 10% for the year to date, with April set to be the worst month for the S&P 500 since the March 2020 Covid outbreak.

The market has had to grapple with a continual flow of negative news. The Russia/Ukraine conflict has reopened security questions in Europe that were thought to have been resolved and forced commodity prices higher. The resultant pressure on food and energy prices is obviously manifest in global inflation prints last seen in the 1970s. The inability of the Chinese authorities to control Covid has heightened fears of further domestic lockdowns. All this has added to global stagflationary fears. The current earnings season has also seen some big misses among previous market darlings (Netflix, Amazon), which adds to market stress as investors reposition.

The real drama, however, is in fixed income. We are beginning the process of interest rate normalisation after a 40-year bull market in bond markets, driven by increasing globalisation and consequent deflationary impulses. This was never going to be a painless event. So far this year, the 2-year US treasury yield has risen by over 200 basis points, the most dramatic sell off since 1994. The US Investment Grade credit index has registered a negative return of over 10%, an unprecedented move for a high quality fixed income asset class. The rise in fixed income yields has become global, another USD 3 trillion of debt that was trading at negative yield has now turned positive again. Ructions in fixed income markets are now also creating more disorderly trading conditions for global currencies, and the dollar has reached its strongest levels since 2002.

The process of interest rate normalisation is not over. However in the short term it is reasonable to expect a period of respite over the summer. Interest rate markets in the US are now pricing a move to 3% for the US Federal Reserve (Fed) funds rate by next March. This is reasonable and likely, in my view. Eventually the Fed may need to move further than this, but we are not likely to know for a while. It is possible that inflationary psychology, against the backdrop of tight labour and resource markets, will become so ingrained that central banks will need to go further. It is equally likely that the global debt overhang will quickly reassert itself and the growth slowdown will be immediate. This is the battleground for macro markets for the rest of this year. Crunch time will be in the autumn. In the meantime, now is not the time to fold. I believe the right strategy is to cautiously add on weakness.

Richard Briggs – Emerging Market hard currency debt

Emerging market (EM) hard currency has undoubtedly had a particularly difficult start to the year, and despite known headwinds, the asset class has now repriced materially, opening up opportunities within the asset class.

If 2022 had ended in April, it would be the worst year for the main hard currency benchmark¹ since 1994 which saw the Mexican peso crisis. A large contributor to these weak returns has been the US Treasury market; expectations of the pace of the US hiking cycle over the next one to two years have brought a huge repricing. We have also seen spread widening, a large component of which is related to Ukraine, Russia and Belarus. The latter two have now been removed from the JP Morgan indices while Ukraine remains on a much smaller share. Spreads were already wide, particularly in EM high yield (HY), going into this year. Even when adjusting for the distressed issuers, EM HY spreads are trading at, or close to their widest spreads over the past decade outside of the Covid-19 sell off in March 2020.

Prices are now lower due to the sharp rise in yields, both due to US Treasuries and credit spreads, reducing downside from here if there is a potential uptick in defaults. Many of the most problematic credits also trade below 50c on the dollar, including Sri Lanka, El Salvador, Ukraine, Argentina and others. Additionally, carry is now substantially higher. The JP Morgan EM Bonds Index Global Diversified now carries a yield of 7.4%, up from just 4.8% as recently as September 2021. That raises the hurdle to negative returns over the next 12 months.

The expectations for US rates are also now significantly more aggressive. Going into September last year, Fed funds futures priced one 25 basis points (bps) hike by the December 2022 meeting. Currently, they are pricing 10 25 bps hikes by the end of the year.

While we see opportunity, the environment remains challenging and selectivity is key. We see opportunities in commodity exporters but we think commodity importers are vulnerable, including Pakistan, Kenya, Egypt and Turkey. Pakistan has already seen a large drawdown of its reserves alongside pressure on its currency; Egypt has seen a large devaluation in its exchange rate and is also a huge wheat importer. It would struggle to issue with most high yield issuers, which are trading with high single digit yields, while Egypt is in double digits. Any issuer with a high need to refinance in the near term warrants caution.

Meanwhile, oil exporters such as Nigeria and Angola have oil break evens significantly below where oil prices currently are, allowing them to build reserves and reduce their debt. Additionally, as Europe is trying to move away from Russian gas exports, we see potential for investment in gas producing countries including Mozambique, Papua New Guinea and Azerbaijan.

Regarding Ukraine, our base case is that it will need to restructure. The authorities are still saying they are going to keep making payments, but we are of the view that it is likely they will do so given the high level of multilateral and bilateral support. That being said, Ukraine’s bonds currently trade in the 30s.