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.
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.
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.
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