The impact of the Fed’s mandate on global growth remains uncertain
In 2023, the Fed’s ongoing fight against inflation, and its consequences on economic growth, will remain front and centre on investors’ minds. The IMF foresees global growth falling to 2.7% in 2023 from 3.2% in 2022 and global inflation dropping to 6.5% in 2023 and 4.1% in 2024, down from 8.8% in 2022. In 2022, the US witnessed inflation prints not seen in decades with figures nearing the double digits. In order to tame inflationary pressures, the Fed embarked on one of its most aggressive tightening cycles, bringing its target policy rate to a range of 4.25% – 4.5% in December 2022 from 0 – 0.25% in January 2022. The aim of imposing higher interest rates is to put downward pressure on consumer demand and investments, which in turn should reduce inflation. This effort to reduce inflation carries its own risk, as reduced economic activity can lead to recession. In 2023, investors will witness the outcomes of the Fed tightening policy, and it has yet to be seen whether the resulting slowdown in growth ends as a “soft landing” (lower inflation, no recession) as hoped by the Fed, or a more profound downturn that leads to a moderate or severe recession.
At Blue Orchard, we believe three scenarios could play out over the next few months.
The first one would be a soft landing, where inflation declines whilst economic activity only slows down moderately. In that context, we would expect the pace of rate hikes to decelerate and nominal rates to stabilise. Our view, in this context, is that unemployment and default rates would remain contained. This would be the best scenario for the economy, and we would expect fixed income assets to perform particularly well.
The second scenario would be one where the global economy dives into a deeper recession and inflation comes down. There, we would expect nominal rates to decline and both unemployment rate and default rates to rise. Further, the USD would likely appreciate given its role as a safe-haven asset. Although risk sentiment would deteriorate, we maintain that fixed income would become a particularly attractive asset class for two reasons. Firstly, in a period of market distress, the correlation between high quality fixed income assets and riskier ones is usually negative. Fixed income instruments would hence act as a diversifier and a hedge in multi-asset portfolios. Secondly, the yield offered by fixed income assets is now sufficiently high to provide performance potential. In other words, in a flight to quality environment, as demand for fixed income rises, yields on those instruments should decline, which would somewhat counterbalance the losses experienced on riskier assets.
A third scenario would encompass a combination of profound recession and persistently high inflation. Although we see it as the least likely option, such a scenario would be punitive across asset classes.
Glimmers of light shine in emerging markets amidst global uncertainties
Whilst the global environment suggests that uncertainty and risk lie on the horizon for the months ahead, glimmers of light are perceivable in emerging markets. It is undeniable that the energy crisis resulting from Russia’s invasion of Ukraine has had particularly severe consequences on Eastern European economies. However, a combination of a relatively mild winter so far, improved supply chains and falling commodity prices should help ease the burden. And even though global growth prospects are uncertain for the year ahead, the relaxation of Covid-19-related restrictions in China, coupled with the government’s rescue package offered to its property sector should provide some relief.
On the monetary policy front, emerging markets central banks, particularly in Latin America, are further ahead in their tightening cycle than their Developed Markets peers. This should thus leave those Central Banks ample room to take rates lower in the coming months in order to support their economies. In terms of valuations, emerging markets look attractive relative to historical standards. As of the end of December 2022, the JP Morgan Corporate emerging markets benchmark recorded a yield of 7.3% and a spread duration of 4.2 years. In other words, spreads would have to widen by 1.7% for the entire benchmark carry, i.e. its 7.3% annual yield, to be wiped out over a full year. Stripping out the period of the first Covid-19 outbreak in early 2020, emerging markets corporate spreads are currently trading towards the upper end of their average over the past five years. We would thus expect any potential move higher in spreads to remain well within 1.7% over the next year. Finally, flows into emerging markets were largely muted in 2022. We would expect them to recover in 2023 which would be a supportive technical for the asset class.
Issuer selection and alpha management will be key in 2023
Over the coming months, we will most likely continue to favour long-dated, high quality Investment Grade names, under the assumption that those instruments would benefits most from falling interest rates. In a soft-landing scenario, we would feel more comfortable with reasonable increases in portfolio risk through the acquisition of long-dated bonds, yielding a longer credit duration in the portfolio. In a recessionary environment, our team would focus on high quality issuers. We would avoid increasing our funds’ exposure to high yield instruments that may be more likely to face illiquidity issues in such an environment.
In the first two scenarios, which we see as most likely, we anticipate numerous opportunities to arise for active portfolio managers. Interest rates and credit spreads trade at valuations not seen in years. Political risks in emerging markets will continue to offer premiums that are uncorrelated to the global leverage cycle. In addition, the broad range of monetary policies across Emerging Market geographies will create dispersions, which active portfolio managers can take advantage of to generate alpha.
Finally, in a “stagflationary” environment, described as the third scenario above, our team would focus on short-dated, high quality bonds to reduce the impact of volatility on our funds and preserve capital.
Whilst it is not our base case, if the third scenario does come to fruition, we believe our portfolios are well equipped to weather the storm thanks to their high quality-bias and significant allocation to highly liquid, AAA-rated supranational entities. In addition, we note that our funds have strategically avoided any exposure to the Chinese property sector, as well as concerns directly linked to Ukraine and Russia, and we expect this strategy to bear fruit as those areas could remain market pain points throughout 2023.
Conclusion
In our view, emerging markets offer very attractive opportunities at present, in particular compared to historical standards. Further, we expect numerous dispersions to arise in the segment given the wide range of fundamental strengths and monetary policies across Emerging Market countries. For example, countries in Latin America are further in their tightening cycle than those in Asia. Political volatility, notably in Latin America, would only exacerbate those dispersions. What is particularly interesting there is that valuations look cheap thanks to a political risk premium which is not correlated to the global leverage cycle. Examples include Peru and Brazil. Despite the uncertainty and challenges in the current environment, we continue to believe that it presents real opportunities for active managers who can leverage market disparities in pursuit of alpha and investor return.
-end-
About BlueOrchard Finance Ltd
BlueOrchard is a leading global impact investment manager and member of the Schroders Group. As a pioneering impact investor, the firm is dedicated to generating lasting positive impact for communities and the environment, while aiming at providing attractive returns to investors. BlueOrchard was founded in 2001, by initiative of the UN, as the first commercial manager of microfinance debt investments worldwide. Today, the firm offers impact investment solutions across asset classes, connecting millions of entrepreneurs in emerging and frontier markets with investors with the aim to make impact investment solutions accessible to all and to advance the conscious use of capital. Being a professional investment manager and expert in innovative blended finance mandates, BlueOrchard has a sophisticated international investor base and is a trusted partner of leading global development finance institutions. To date, BlueOrchard has invested over USD 10 billion across more than 105 countries. Over 260 million underserved people and MSMEs in emerging and frontier markets received access to financial and related services with the support of BlueOrchard as of December 2022. For additional information, please visit: www.blueorchard.com.
For further information, please contact:
Tahmina Theis
+41 44 441 55 50
tahmina.theis@blueorchard.com
Important Information
Marketing material for professional clients and for qualified investors in Switzerland only.
Please refer to the prospectus and any other legal document of a fund before making any final investment decision.
The information in this publication was produced by BlueOrchard Finance Ltd (“BOF”) to the best of its present knowledge and belief. However, all data and financial information provided is on an unaudited and “as is” basis. The opinions expressed in this publication are those of BOF and its employees and are subject to change at any time without notice. They do not necessarily reflect the opinion of Schroders Group.
BOF is part of Schroders Capital, the private markets investment division of Schroders Group.
BOF may decide to cease the distribution of any fund(s) in any EEA country at any time but we will publish our intention to do so on our website, in line with applicable regulatory requirements.
This publication is provided for marketing reasons and is not to be seen as investment research. As such it is not prepared pursuant legal requirements established for the promotion of independent investment research nor subject to any prohibition on dealing ahead of the distribution of investment research.
This publication may contain information, references or links to other publications and websites from external sources. BOF has not reviewed such other publications and websites. BOF in particular does neither guarantee that such information is complete, accurate and up-to-date nor is BOF responsible in any way in relation to the content of such publications and websites.
The information in this publication is the sole property of BOF unless otherwise noted and may not be reproduced in full or in part without the express prior written consent of BOF.
All investments involve risk. Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested. Exchange rate changes may cause the value of investments to fall as well as rise. Performance data does not take into account any commissions and costs, if any, charged when units or shares of the fund are issued and redeemed.
Emerging markets impact investments involve a unique and substantial level of risk that is critical to understand before engaging in any prospective relationship with BOF and its various managed funds. Investments in emerging markets, particularly those involving foreign currencies, may present significant additional risk and in all cases the risks implicated in this disclaimer include the risk of loss of invested capital. To understand specific risks of an investment, please refer to the currently valid legal investment documentation.
This publication may contain “forward-looking” information, such as forecasts or projections. Please note that any such information is not a guarantee of any future performance and there is no assurance that any forecast or projection will be realised. Scenarios presented are an estimate of future performance based on evidence from the past on how the value of this investment varies, and/or current market conditions and are not an exact indicator. BOF does not in any way ascertain that the statements concerning future developments will be correct. Unless this fund contains a capital guarantee, what you will get will vary depending on how the market performs and how long you keep the investment/product. Performance is subject to your individual taxation circumstances which may change in the future.
Any reference to sectors/countries/stocks/securities are for illustrative purposes only and not a recommendation to buy or sell any financial instrument/securities or adopt any investment strategy.
The materials provided in this publication are for informational purposes only and nothing in this publication can be construed as constituting any offer to purchase any product, or a recommendation/solicitation or other inducement to buy or sell any financial instrument of any kind and shall not under any circumstances be construed as absolving any reader of this publication of his/her responsibility for making an independent evaluation of the risks and potential rewards of any financial transaction.
We note in particular that none of the investment products referred to in this publication constitute securities registered under the Securities Act of 1933 (of the United States of America) and BOF and its managed/advised funds are materially limited in their capacity to sell any financial products of any kind in the United States. No investment product referenced in this publication may be publicly offered for sale in the United States and nothing in this publication shall be construed under any circumstances as a solicitation of a US Person (as defined in applicable law/regulation) to purchase any BOF investment product.
The information provided in this publication is intended for review and receipt only by those persons who are qualified (in accordance with applicable legal/regulatory definitions) in their respective place of residence and/or business to view it, and the information is not intended under any circumstances to be provided to any person who is not legally eligible to receive it.
The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations. Any recipient of information from this publication who wishes to engage with BOF in furtherance of any transaction or any relationship whatsoever must consult his/her own tax, legal and investment professionals to determine whether such relationship and/or transaction is suitable.
By no means is the information provided in this document aimed at persons who are residents of any country where the product mentioned herein is not registered or approved for sale or marketing or in which dissemination of such information is not permitted.
Persons who are not qualified to obtain such publication are kindly requested to discard it or return it to the sender.
BOF disclaims all liability for any direct or indirect damages and/or costs that may arise from the use of (whether such use is proper or improper), or access to, this publication (or the inability to access this publication).
The BlueOrchard managed funds have the objective of sustainable investment within the meaning of Article 9 Regulation (EU) 2019/2088 on Sustainability related Disclosure in the Financial Services Sector (the SFDR). For information on sustainability related aspects of this fund please go to https://www.blueorchard.com/sustainability-disclosure-documents/ .
Investment or other decisions should be made solely on the basis of the relevant legal fund and investment product documents (prospectus/offering memorandum, fund contract/articles, key information documents, financial reports etc.).
It is important that you read the relevant fund and investment product documents before you invest in financial instruments to ensure that you understand the investment policy, expenses, specific risks involved and other important matters, to determine whether it is a suitable product for you.
Third party data is owned or licensed by the data provider and may not be reproduced or extracted and used for any other purpose without the data provider’s consent. Third party data is provided without any warranties of any kind. The data provider and issuer of the document shall have no liability in connection with the third-party data. The Prospectus contains additional disclaimers which apply to the third-party data.
For readers in Switzerland: Marketing material for professional clients and qualified investors only. This document has been issued by BlueOrchard Finance Ltd, Seefeldstrasse 233, 8008 Zurich, a manager of collective assets authorised and supervised by the Swiss Financial Market Supervisory Authority FINMA, Laupenstrasse 27, CH-3003 Bern.
BOF has outsourced the provision of IT services (operation of data centers, data storage, etc.) to Schroders group companies in Switzerland and abroad. A sub-delegation to third parties including cloud-computing service providers is possible. The regulatory bodies and the audit company took notice of the outsourcing and the data protection and regulatory requirements are observed.
A summary of investor rights may be obtained from https://www.blueorchard.com/imprint/
Copyright © 2023, BlueOrchard Finance Ltd. All rights reserved.