Investment Manager Research Highlights

In the past decade or so the additional tier one (AT1) market has experienced occasional semi-cathartic events that naysayers jumped on to pronounce that the market is dead. Of course, this was never true, just as it isn’t true this time. It usually ends the same way – with some unfortunate casualties, but also plenty of opportunities.

Amid aggressive monetary tightening, the short duration profile of high yield bonds can help defend against rising rates.
Short-dated high yield bonds can offer enhanced yield, lower duration and higher risk-adjusted returns.
In the current environment, short-dated high yield bonds present interesting investment opportunities as they offer over 90% of the yield of the overall high yield market with about half the typical duration risk.

In what is turning out to be a challenging year for global stock market returns, the performance of India stands out within the emerging market asset class and global stock markets. In the nine months through the end of September, MSCI India has fallen by 9.7%, compared to the Emerging Markets index that is down 27.2%. Within Asia, only Indonesia and Thailand have performed better than India this year. This builds on a base of very strong long term returns, with India having outpaced the EM index over most time frames. The result has been that the weighting of India within the MSCI Emerging Markets index has increased further, reaching an all-time high of 15.3% by the end of the third quarter. As a result, India’s weighting has eclipsed both Taiwan and Korea, becoming second only in size now to China.

KEY TAKEAWAYS • The excess yields available from investment-grade and high-yield corporate bonds are beginning to attract “crossover” investors • Asset-backed securities look attractive in the current rising interest rate environment given their shorter duration • Including securitised credit in a fixed-income portfolio could provide diversification benefits due to its lower correlation with corporate credit • Security selection will likely be the key to alpha generation for securitised credit in the coming years.

Benjamin Graham, if he were alive today, or even an investor from 2019, might struggle to comprehend the bull market we witnessed in SPACs, crypto, stonks and NFTs. A year ago, investors were buying monkey jpegs for millions of dollars or profitless tech companies promising jam tomorrow. This extraordinary period was a bull market in the willingness to believe. But exposing the truth has drawn a tear.

Not surprisingly, anti-beta equity strategies did very well for investors who followed them in 2022 – after all, performing well when the stock market as a whole is doing poorly is exactly what such strategies are supposed to do, and 2022 was a very bad year for equities. Now, investors are hoping 2023 will bring respite from central banks’ punishing interest rate hikes and a resurgent stock market, and many might be thinking equity hedging will no longer be a winning strategy. They might be wrong.

Part II of the series shows that deglobalization implies a regime change, with trend increases in capex and the labor share, as well as a higher cost of capital, lower potential growth and greater government involvement in the economy. This constitutes a secular headwind for margins and free cash flow (FCF), especially for tech and manufacturing • We are not returning to the low inflation, zero real interest rate 2010s. Further, with the end of the “Great Moderation,” we expect higher macro volatility (of GDP, inflation, interest rates and FX). • With companies facing a higher weighted average cost of capital (WACC), we expect lower average multiples. This will prove especially challenging for longer duration assets, such as venture capital and speculative tech companies that are years away from generating FCF on a sustainable basis.

Key Takeaways: Caution is warranted entering 2023, however volatility could present intriguing buying opportunities • Although headwinds persist, the solid fundamental starting point should help most companies weather a slowdown and result in a persistently low default rate • Spreads could widen if a recession becomes more imminent. However, elevated yields and discounted bond prices look attractive and we believe high yield could surprise to the upside and generate coupon-plus returns.

In recent years alternative fixed income assets such as mortgage loans, infrastructure financing and private debt have become much more important categories for institutional investors. They can provide opportunities to increase portfolio yield when the (often lower) liquidity of these assets is not a constraint. This is typically the case for long-term investors, such as pension funds and life insurance companies.

Growth strategies have long overshadowed dividend strategies. However, changing macroeconomic conditions have turned the tables and dividend investments are enjoying their time in the sun. While this coincides with value’s long-awaited comeback, value and dividend stocks have distinctive characteristics. We believe that dividends deserve to stay in a portfolio even when economic conditions improve. By adopting a fundamental approach to identify companies that can consistently pay and grow their dividends, investors could achieve long-term real return generation throughout the investment cycle.

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We see danger ahead. Markets are still too high, and protection is expensive in an increasingly nervous world; common sense suggests one should invest conservatively, and in safe assets. In a world where people find themselves without the ability to pay commitments as they arise, forced selling drives prices. Among risky assets like equities, one of the counter-intuitive things in a liquidity crisis is that securities perceived as safest and most liquid go down sharply, because investors are forced to sell what they can, not what they want to. We therefore regard plentiful liquidity in the portfolio as overwhelmingly attractive; it allows us to make the most of the opportunities that arise in the aftermath of a crisis. But first we have to get through the storm.

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An allocation to high-quality, developed market government bonds continues to play an important role in reducing the volatility of a well-diversified portfolio. However, there is no getting away from the fact that, despite recent rises, yields in developed country bond markets are low by historical standards and often fail to compensate even for relatively modest projections for inflation. Given the secular forces that have led to the long-term decline in equilibrium real interest rates, this situation is likely to persist. An allocation to Emerging Markets Debt (EMD) can complement traditional fixed income by enhancing long run returns and acting as an important diversifier within global portfolios.

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US commercial real estate (CRE) investors are well-versed in the importance of economic growth to property investment performance. Focus on the Covid-19 recession, policies to truncate it, and the path of recovery have dominated the attention of analysts for more than two years. Macroeconomic factors continue to dominate attention now, well into 2022, as inflation in the Covid-recession’s aftermath complicated by Russia’s invasion into Ukraine have taken the spotlight. All eyes are now on the prospects for the US Federal Reserve (Fed) to accomplish a soft landing. Looking further ahead, US CRE will confront another challenge embodied in weakening demographics. In the paragraphs below, we identify the components of weakening demographics measured nationally and highlight differences across US metro areas. The differences illustrate the importance of careful metro market selection to counter demographic headwinds in the years ahead.

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Investments in US Low-Income Housing Tax Credits (LIHTC) are an excellent example of impact investing. Impact investing seeks to create positive social or environmental benefits in addition to financial returns. To call an investment an “impact investment”, it is necessary to have an agreed upon understanding of what benefits are generated in addition to financial returns, as well as a mechanism for measuring those positive impacts.

In this paper we explain the basic workings of the program, investigate some of the positive effects it has on lower-income residents and society, and discuss ways these impacts could be quantified.

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The thought that central bankers can do much to change the broad sweep of inflation is, in my view, far-fetched. Lowering interest rates and keeping them down ensured that, in the aftermath of the 2008 crash, the world escaped a dislocative deflationary recession, and experienced instead a reprieve from deflation. Their actions, however, had an inevitable consequence: the onset of a virulent inflation. This was perfectly predictable at the time, and, indeed, we predicted it.

There was, however, no money to be made from the insight that money had lost stability post-2008 – the car would swerve maybe towards deflation, maybe towards inflation, but the final result would certainly be inflationary, because the authorities’ obsession was (and is) to avoid deflation. The game changer was to be rightly prepared for inflation, and for the last ten years, we have been. To call it too early is, in our book, to call it on time.

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Against the US dollar, the Japanese yen is at a 24-year low. Over the same period, the domestic purchasing power of the dollar has almost halved, whilst that of the yen has barely moved.

KEY TAKEAWAYS

The BOJ’s resistance to tighter policy and higher JGB yields is understandable, but this is not a sustainable situation. Within equities, the impact of a weak yen varies from sector to sector. The BOJ is facing two bad choices: continue to allow the yen to weaken, sapping purchasing power; or, raise rates, likely leading to a drag on economic activity.

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China stocks are slumping on news of rising COVID-19 cases in the world’s most populous country but that doesn’t negate their strong rebound in recent months. The MSCI China Index has still risen by more than 20% since early-May, according to Bloomberg, when it hit what now appears to be a trough. That is a remarkable recovery, given that the world’s second largest economy has been challenged this year by COVID-19 flare-ups – including one that led to a lockdown of Shanghai, home to the world’s largest seaport, in the spring – as well as continuing global supply chain constrictions and uncertainty around Beijing’s regulatory crackdown on technology stocks. Only a few months ago, those factors led some Western market-watchers to openly wonder if China had become “uninvestable.” So for those investors who rode out the downturn, the recent uptick in China stocks is surely welcome. The question, however, is whether the recovery is sustainable.

Expect an Increased Focus on Capital Allocation, Quality and Sustainable Free Cash Flow

Until recently, we had been in a disinflationary environment since the 1980s, when Volcker helmed the Fed. This secular trend reflected three forces: (1) Correcting the policy mistakes made in the ’60s and ’70s that stoked stagflation, (2) the increasingly globalized nature of trade, investment, and finance from the mid-1980s, and (3) the deflationary impact of tech, which has been especially impactful during the last two decades. While the latter factor remains in place, we believe it is being overwhelmed by the 3Ds — Deglobalization, Demographics and Decarbonization — meaning we have entered a secular reflationary environment.

The remainder of this note briefly explains each of the three Ds and then concludes with a discussion of what all this means for investors.

While there are reasons to be both positive and negative about global equity markets, a more cautious case is gathering momentum. Inflation is now 8.5% year-on-year in the US, while GDP expectations are being revised downwards. Most cycles of tightening by the US Federal Reserve end in recession and this may be no different.

This article by Aegon AM's global equity income team explains why a dividend-focused global equity strategy is worth considering in such an uncertain environment.

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The market cap of cryptocurrencies peaked in late-2021 at $3.0 tn and has since plummeted to around $1.3 tn. The primary catalyst for this decline has been an increasingly hawkish Fed with financial conditions tightening by the most since the global financial crisis. The drying up of liquidity has negatively impacted all risk assets, but with an especially pronounced impact on crypto.