Avoiding unforced errors in 2023

For financial advisers and professional investors only – not for distribution to retail investors.

06 February 2023

Is an underweight position in fixed income exposing your portfolio to unforced errors?

2022 has been a challenging year for most investors with global financial markets performing poorly amid drawdowns across both fixed income and equity markets. Naturally, given the protracted low yield environment we operated in, many investors have retained a lower exposure to fixed income assets. Looking forward however, in our view, the sharp repricing in global fixed income markets is offering yields not seen in over 10 years, creating highly attractive valuation opportunities. In parallel, the accommodative macro environment, characterised by uncertain growth and likely moderating inflation, provides a further tailwind to fixed income, provoking the question - is an underweight position in fixed income exposing your portfolio to unforced errors?

The backdrop for the 2023 season

Expect inflation to moderate

Globally, central banks are currently undertaking the most aggressive tightening cycle in decades, coupled with quantitative tightening, in an attempt to stifle inflation. Analysing the contributing factors to inflation reveals most near-term stressors are in the process of peaking or have already peaked, and likewise base effects continue to exert downward pressure with the monthly US inflation prints rolling off in Q1 2023 being 0.6%, 0.8%, and 1.2%. As such, it appears likely that inflation will continue to moderate into 2023, barring any exogenous shock.

Central banks normally hike when growth is hot… this time it’s not

The current environment is best characterised as a low/no-growth, and high-inflation world – in other words, stagflation. A key takeaway from our research of similar environments is that periods of stagflation are typically followed by lower growth, and by association, recessions. While a handful, of mostly lagging indicators, still show some signs of resilience, it is becoming visibility apparent that global growth is slowing meaningfully, with all signs pointed toward recession. Against a backdrop of weakening growth, unprecedented tightening of both monetary and fiscal policy will likely tip economies into recession in 2023, the severity of which will likely be determined by the level at which inflation settles.

High debt levels and high bond yields are not natural dance partners

Fixed income to take centre court

The impending macroeconomic landscape we have described; moderating inflation, recession risk and structural imbalances, we believe justifies a significant allocation to fixed income markets, especially if the recessionary conditions turn out to be worse than anticipated. This supportive macro backdrop coincides with once-in-a-decade valuation opportunities, thus setting the stage for fixed income to take centre court in 2023 with the safe havens of cash and bonds looking highly attractive. For those investors seeking additional yield via an allocation to credit, fundamentals continue to remain solid in both investment grade and high yield. However, given the macro backdrop, defensive positioning within high quality credit is likely most appropriate for the time being.

The grand slam

In the context of tennis, a grand slam refers to winning all four major championships in a calendar year. Extending this to investing, the grand slam for fixed income entails attractive valuations and returns, solid income levels and protective diversification, all of which play a key role in a diversified portfolio.

Attractive valuations

The considerable rise in bond yields and credit spreads, to levels not seen in over a decade, offers highly attractive valuation levels, noting that bond prices move inversely to yields.
These levels are increasingly compelling considering the uncertain macro-economic backdrop, in which bonds typically outperform, as well as the likely moderation in global inflation, suggesting that not only is the outright level of bond yields attractive but there is potential for additional capital return via a fall in yields.
As such, while a period of heightened volatility is likely to continue in the immediate term, duration is offering an increasingly attractive opportunity for long-term investors.

Attractive return outlook

Attractive valuations go hand in hand with an attractive return outlook, given higher yields positively skew return outcomes going forward.
For example, a fall in yields of 1% would be enough to generate close to double digit returns for an investment in a US 10yr government bond for the year ahead.
Furthermore, historically, fixed income markets have typically rebounded after big losses. Each of the 5 largest bond sell-off years have been followed by a strong rebound, with an average return of over 15%.
This pattern illustrates a reality of bond pricing: large losses lead to higher yields, which positively skews outcomes looking forward. With 2022 being one of the largest losses, the return outlook has the potential to be very attractive

Solid income levels

Whilst the ride may remain somewhat bumpy, fixed income investments are now cushioned by the increased level of income (or coupons). This provides a key source of total return from fixed income investments and offers a greater level of protection against capital loss.
Comparing select corporate bond and dividend yields, an allocation to fixed income securities can now provide both a higher as well as more predictable and reliable source of income for investor portfolios.
From a broader market perspective, US investment grade credit, a high-quality asset class, now yields the same as US large cap equities for the first time in over a decade, whilst offering a more favourable historical volatility experience and stronger downside protection.

Protective diversification

In 2022, markets displayed unusual (and outright ugly) performance, with global fixed income and equity markets disconnecting from historical correlations, which saw both asset classes sell off.
In fact, it was the first time in over 20 years that both global bonds and global equities sold off. Typically, during a calendar year in which the return on global equities is negative, global bonds outperform by an average of 26%.
Looking forward, we expect bonds to reconnect with the cycle, given bonds almost always rally in a recession.
If so, bonds will likely exhibit a lower level of risk whilst providing a protective buffer to a diversified portfolio during times of stress.

Avoid unforced errors

Investing, much like a match of tennis, requires a long-term strategy and a resolute focus on risk management, aiming to minimise undue risk or unforced errors. As we head into 2023, is an underweight position in fixed income exposing your portfolio to unforced errors? With much more attractive yields for low-risk assets, amidst increased general market volatility, fixed income may be poised to return to a role it has struggled in for several years: a relatively stable source of attractive total returns for a broader investment portfolio. Game, set, match.

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Diversification may not protect against market risk.

Fixed income securities and bond funds can lose value, and investors can lose principal, as interest rates rise. They also may be affected by economic conditions that hinder an issuer’s ability to make interest and principal payments on its debt. The Fund may also be subject to prepayment risk, the risk that the principal of a bond that is held by a portfolio will be prepaid prior to maturity, at the time when interest rates are lower than what the bond was paying. A portfolio may then have to reinvest that money at a lower interest rate.

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