BMO announced the expansion of the Latino Leaders Index500, a ranking of the 500 largest Latino-owned businesses in the U.S. by revenue, as part of its exclusive partnership with Latino Leaders Magazine. Nationally recognized businesses such as MasTec, Carvana, and Goya rank high on the list.
The businesses featured throughout the Latino Leaders Index500 represent a wide range of industries, including engineering and construction, transportation, retail and more. They are headquartered in 34 different states – with particularly strong presence in California with over 100 businesses represented, as well as Texas and Florida. 180 of these businesses generated $100 million or more in revenue in 2023, showcasing their size and strength across a multitude of industries, as well as their impact on the communities in which they operate.
“BMO is extremely proud to contribute to the growth of the Latino Leaders Index500, Powered by BMO and to continue our relationship with Latino Leaders Magazine,” said Eduardo Tobon, Director, Economic Equity Advisory Group, BMO. “Expanding from 200 to 500 companies speaks volumes about how important and valuable Latino businesses are to the American economy. BMO is committed to supporting Latino businesses with access to capital, educational resources, and meaningful networking opportunities to help them make real financial progress.”
Latinos are the largest minority group in the United States, compromising 19 percent of the population, and drive over $3.2 trillion in economic output to the U.S. economy.
BMO recognizes Latino business owners continue to face barriers to inclusion, which is why the bank promotes equal access to opportunities that enable growth for its customers, colleagues, and the communities it serves.
For quite some time, our team has contended that goods inflation is indeed transitory. While a slowdown has taken longer than we originally thought, goods inflation is indeed falling. However, the Fed’s chicken-and-egg dynamic of inflation first before rate hikes has them playing catch-up quite aggressively. Other than the recent bank failures, the headline-grabbing data points over the past few months are mostly encouraging and now tell a story of retreating inflation. Although CPI slowed from 9.1% year-over-year in July to 6.4% year-over-year in January, the Fed still needs to keep its foot firmly on the brake.
Slowing inflation is just one part of the equation. While the Fed’s success may allow them to moderate the pace of interest rate hikes or eventually hold rates at a high level, Chairman Powell and the rest of the Fed must also work to restore credibility. In fact, Chairman Powell reiterated his message that inflation remains a way off from where they need to see it and there is more work to do, even as the Fed slowed its tightening pace in February.
Inflation peaked last year in July. Since then, we’ve experienced a slow and steady decline in the headline number. We’ve also seen services inflation taking an increasing share of the price pressures and goods inflation taking a decreasing share. As I have argued, this is important in terms of the Fed’s third mandate, which I believe will determine the timing of the central bank’s pivot. If services inflation remains above two percent, though lower than where we see today, and goods inflation keeps shrinking, the Fed may tolerate core inflation above 2%. Given that services inflation is heavily driven by rising wages, and today, much of this increase is focused on the lower-income population, the Fed views this as ‘good’ inflation. For some time, I have argued that the Fed’s third mandate is one of social stability, or more succinctly, compressing the wage gap.
Chair Powell and the Fed’s race to cross the 2% inflation finish line is made more difficult by the strong US economy headwinds blowing in their faces. Imagine also trying to do this while wading through a flood of government spending stemming from December’s omnibus spending bill. In other words, this battle against inflation is at odds with the easy fiscal policy crosscurrents. Unsurprisingly, I think it will be more difficult for the Fed to go from 6% to 2% inflation than it was to shed the excesses from 9% to 6%.
The silver lining to all of this is that a tightening Fed means that yield and income are back! Investing in T-bills or two-year treasuries will not provide a better economic outcome than investing in areas in which investors can earn a credit risk premium. For a while now we have suggested that the economy will be more able to perform into higher rates. However, we have also said that our belief is that there is such thing as rates too high to sustain growth. We think that about 3.75% is fair value for the 10-year treasury, and we are opportunistically adding protection with treasuries when rates rise above this level and reducing duration when we have seen rates notably below this level. We work to balance the opportunity in both credit and rates and expect that volatility will remain high throughout the year.
Away from rates, all the talk about an imminent recession has pushed spreads further above treasuries in most areas of the market. Given the ongoing strength in consumer spending, we believe the best relative value on a sector level continues to be in securitized debt. These non-agency, asset-backed securities spreads on the AA to BBB ratings spectrum are wider than investment grade corporates.
Although this is generally the case, today’s premiums are wider than usual. We favor ABS and residential mortgage-backed securitized credits, which provide additional protection in the form of fast paydown and underlying collateral to provide some ballast when—not if—we enter a recessionary environment.
We prefer prime borrowers through bonds backed by consumer loans and autos because subprime customers are much more sensitive to evaporating stimulus and heightened inflation. When we elect to take on subprime exposure, it’s because we believe the bonds are “senior” in the capital structure and these bonds tend to pay down very quickly.
Many investors also ask about emerging market debt. We are cautious and selective in these spots given their inherent high levels of global risk. But slowing U.S. growth means EM growth differentials are more favorable in 2023 and an eventual pivot from the Fed will slow the rise of the dollar.
In terms of credit quality, we favor investment-grade corporate bonds over high-yield corporates. In an environment of weak growth, we are weighted toward non-cyclical names in utilities, healthcare, select tech, and high-quality financials. We won’t close the door entirely on high yield—seven to eight percent would capture any investor’s attention¬—but as with emerging markets, we pair our robust bottom-up, fundamental process with a top-down view to be highly selective in our approach.
Looking ahead, we still see some red lights on the dashboard. Few investors have weathered an inflationary storm like this, and the inflationary environment last time was radically different. The last decade’s game of monetary and fiscal stimulus has had profound effects on the global economy, and without a playbook, it’s hard to predict how this experiment may end. Caution is the only rule, and we believe we are positioned well to capture yield and remain defensive.
Tribune by Jeff Klingelhofer, CFA, is Managing Director and Co-Head of Investments at Thornburg Investment Management.
This bearish cycle is the first major test for precious metals ETFs, whose holdings skyrocketed in 2020, fell two years diagonally, rebounded in 2022, and have been falling almost unabated for 10 months. So far, the test is not satisfactory. Even with the price rally between October and January, and now in March, investors seem skeptical and tend to further reduce the investment.
Gold investments go up and down like a roller coaster
ETFs that track the trajectory of gold and silver rose to prominence in the mid-2000s and grew to absorb the majority of production. Holdings of GLD, IAU and others (histogram) reached 83 million ounces (M) −about 157,3 billion dollars (B) − in 2012 due to the tremendous rise in price to $1.895 from $377 (line); from there they fell 45% to 46M in 2015 due to the collapse of the metal, also 45%; they recovered to 69M in 2016 and continued to grow to 111,4M in 2020, in the midst of the pandemic. The enchantment began to reverse. The prolonged reduction stopped in January 2022, around 98M. From there the brilliance reappeared, intensified by the outbreak of the Russia-Ukraine war that pushed the price back to the all-time high of $2.000 (white line). And since May the global investment descends like a roller coaster due to the Fed’s monetary policy, a true factor of price variation. The slide appeared to slow at 94M in October, as gold returned to the range it had been in before the Covid era, but continued at a less pronounced pace. As of March 10, the fall sharpened to 91,8M, −166.2 B−, 17% below the highest peak and 14% below the last year high, although 7 days later they were 92,4M −around 182,3 B−.
Managers (or retail investors) did not react in November-December to the price improvement to $1.950, the threshold of the highest peak: holdings fell beyond the level they were in September-October, when the metal was trading at the lowest rank in almost four years. Instead, they did react to the dip to $1.836 in February, reducing holdings to April 2020 levels.
Silver holdings: two-year stability distorted by the Fed
SLV, SIVR and others (grey histogram) increased their silver positions to 504M −24,4 B− in 2011, when the price skyrocketed to $48.50. By 2015 they had reduced them by 13% in response to the decline of 72% of the metal to $13.90, to stabilize them in the following 8 years around 550M and increase them, due to the monetary frenzy, by 75%, to 896M, between 2019 and 2020, when the price went up to $29 (white line). Investments stabilized between August and December of that initial year of the pandemic to suddenly rise vertically, up to 1.02B in February 2021, due to the call on Reddit to “squeeze” the metal. Since then they have decreased. See the precipitation from May. Last January, global investment fell 28% from the peak and 19% from the 2022 high to 739M, June 2020 levels. As of March 17, it recovered to 752,8M −15,4 B−, reducing the drop to 26% and 17%, respectively.
The decline in holdings, completed just two months ago, was the result of the price falling from $26. An ounce bottomed out at $17.60, from where it began to improve, although the decline in holdings did not abate. As in the case of gold, managers or investors were indifferent to the rise to $24 between October and December and even hurried selling until holdings fell to 739M, levels at the start of the pandemic, in June 2020. But they saw something come out to buy in January raising assets to 764M even as the rally petered out. What is interesting, unlike in the case of gold, is that the selling was stopped even though the white metal fell back to $20,60.
First serious test for gold and silver ETFs
Holdings already influence the direction of prices. The only precedent for the reaction of managers and/or investors to monetary tightening and the free fall of gold and silver, is that of 2011-2015, which may not be useful to infer how they will continue to act now. The disenchantment with gold, which is widely used for hoarding and ornamentation, is relevant. Regardless of the differences in attitude towards one metal and the other, one thing is clear: Holdings are back to numbers of three years ago and may be further reduced. Although prices are higher than then, precious metals do not hedge money from the loss of purchasing powerand that the fundamental factors (production, demand, use in solar panels and vehicles, etc.), do not affect the prices. And the outlook is clearly not rosy. Continued selling suggests investors do not expect prices to return to high levels.The rallies seem to be used to sell, not to restore positions. Although the possible softening of the Fed due to fears of a new banking crisis is priced in, (gold rebound to around $1.970, silver around $22,50), pessimism is more permeable.
High yield slumped alongside other asset classes in 2022, with the ICE BofA US High Yield Constrained Index declining -11.21%. Yields increased a hefty 4.7% on the year, rising to 9.0%. Only 37% of the increase in yield was
driven by spread widening, as the market’s option-adjusted spread (OAS) increased a relatively modest 172 bps to a spread of 483 bps.
“Looking forward, we view valuations as very attractive on a yield basis – both US and European high yield are in the cheapest yield decile over the last 10 years. Despite the slowing economy, we are constructive on high yield, forecasting 10-12% returns for the full year 2023. Our spirited outlook is based on the asset class’ relatively healthy fundamentals, highly supportive market technicals, and the attractive yields on offer that help to compensate for the risks of investing in high yield”, reports Nomura Corporate Research and Asset Management INC (NCRAM) in the “High Yield Outlook”.
Mixed Macroeconomic Backdrop
2022 was a year to remember for both risk assets and rates investors, as neither equities nor fixed income provided any respite from the relentless bear market. The S&P 500 declined -18.1%, and the 10-year US Treasury lost -16.3%. Other developed and emerging markets witnessed similarly distressed outcomes for their domestic 60/40 portfolios. Commodities lost their effectiveness as a hedge after an early -2022 rally. WTI crude gained 4.2% on the year, falling -35.1% from its zenith in March.
The year began with the US Fed tacitly acknowledging that surging inflation would not be “transitory.” The Fed and many other global central banks spent 2022 aggressively withdrawing the liquidity they had pumped into their economies during the pandemic. One notable anecdote is the decline in US M2 money supply growth from a shock-and-awe level of 26.8% y/y during the pandemic to 0% annual growth in November 2022, the slowest pace since at least 1959. Market sentiment subsequently shifted from fretting about inflation to worrying about a pending recession. Russia’s invasion of Ukraine added to investors’ consternation in 2022, particularly in Europe, driving up commodity prices and further snarling supply chains.
As the year progressed the global economy softened, sapping demand for commodities and providing firms with breathing room to catch up on backorders and otherwise normalize supply chains, enabling inflation to retreat from peak readings.
As the calendar turns to 2023, says NCRAM, investors remain concerned that the Fed may channel the King of Pop, Michael Jackson, and his “Don’t Stop ‘til You Get Enough” refrain, driving the US economy into recession as a side effect of its efforts to contain inflation.
NCRAM is somewhat more sanguine about the economic outlook. “While we forecast a shallow recession in 2023, we also expect the Fed to pause rate hikes in 1Q23, and the economy to begin its recovery in the second half of the year in anticipation of easier monetary conditions”. According to the outlook, the Fed could begin easing before year-end if inflation and growth continue to react to the 425 bps of tightening plus early stage QT that the Fed implemented in 2022. Markets are unlikely wait for the economic recovery to take hold before rallying, creating a more favorable environment for investing in 2023.
Supportive High Yield Fundamentals
Despite the slowing economy, high yield fundamentals remain relatively sound. US high yield issuers ’ 3Q EBITDA declined -6% sequentially, but rose 17% y/y. High yield companies continue to generate cash flow and are using those resources to prepare for a weaker economy. Leverage in the US high yield market has declined from 5.2x during the pandemic to 3.1x to start 2023.
“The default rate over the last 12 months has held steady at less than 1%. We expect a small increase in defaults as the economy slips into a shallow recession, but given the low leverage carried by high yield issuers and the absence of a market sector under significant stress (e.g. energy in 2015-16 or housing during the financial crisis), we expect the default rate to remain below the 3.2% long-term average. Another reason we are confident that defaults will remain under control is the improvement in credit quality in the US high yield market in recent years. Historically, the high yield market has seen as low as 35% BB-rated bonds, and coming out of the financial crisis, nearly 25% of the market was rated CCC and below.”
Today the market is more than 50% BB, and only about 10% CCC. High quality issuers are generally better positioned to withstand a recession.
Muscular Market Technicals
High yield technicals are very robust, according to NCRAM’s outlook. The US high yield market shrank by nearly $200 billion of market cap in 2022. Calls, tenders, and maturities totaled close to $200 billion for the year. More than $100 billion of high yield bonds were upgraded to investment grade, countered by less than $10 billion of investment grade that was downgraded to high yield. This means that close to $300 billion left the high yield market in 2022 vs. just over $100 billion of new high yield issuance. The nearly $200 billion decline in high yield
bonds outstanding (excluding secondary market buybacks by high yield issuers) is more than 10% of total US high yield market cap (market size is just shy of $1.5 trillion).
“We expect the rising star trend to continue in 2023, as large issuers such as Occidental Petroleum and
Ford could potentially ascend to investment grade. High yield issuers were able to avoid tapping the market in adverse conditions in 2022, because much of the debt stock that would have come due last year was refinanced in the heavy issuance years of 2020-21. There are few high yield bonds maturing before 2025, and approximately 80% of high yield issuers have no bond maturities in the next 2 years, another reason we are confident that defaults will avoid a spike in 2023.”
Attractive Entry Point
The yield to worst for both US and European high yield is quite generous relative to recent history, even if US high yield is not overly cheap on a spread basis. “We believe the yields on offer, along with the previously described fundamental and technical backdrop, support our forecast of 10-12% high yield returns in 2023”, says NCRAM.
JP Morgan Research calculates that over the last 37 years, when investors have put money to work in US high yield with yields of 8-9%, the median 12-month forward return was 11.4%. Given the improved credit quality profile of the market, one would expect investors to demand a lower risk premium to hold high yield.
Thus, NCRAM estimates that US spreads look more attractive relative to history on a quality-adjusted basis. Also note that average high yield bond prices in both the US and Europe are trading close to their deepest discounts in
the last decade, improving the risk-reward ratio for an asset that (if all goes well) matures at par.
NCRAM’s total return forecast assumes the US will lapse into a mild recession, but the high yield market will be able to ride out the slowdown. “Even if our growth forecast is too optimistic and the recession is more painful than expected, rapidly declining US Treasury yields would counter-balance high yield spread widening. With carry around 9%, we believe high yield will generate positive returns even if the depth of the recession surprises to the negative side”, concludes the NCRAM’s outlook.
The key trends to look out for in science, technology and sustainability over the next 12 months – and beyond:
1. Protecting biodiversity
The world is waking up to the fact that protecting biodiversity is just as important for our survival on Earth as halting global warming. At the UN COP 15 summit in Montreal in December 2022, governments signed a ground-breaking deal to halt biodiversity loss by 2030. To achieve this, we will need to harness new and existing technologies to embed more sustainable practices across industries such as agriculture, forestry, IT, fishery, materials, real estate, consumer discretionary and staples, utilities and pharmaceuticals. Following COP 15, the financial sector is expected to increasingly contribute to this transition. The OECD estimates that investments aimed at protecting biodiversity stand at less than USD100 billion a year – a paltry sum, particularly when compared with what climate change attracts (USD632 billion). Expect that gap to slowly start closing in 2023.
2. High-tech cars
New technology brings disruption and opportunities to almost every industry. The auto sector is no exception. Electric vehicles are becoming ever more popular – not least thanks to the recent surge in petrol prices. 2023 will see new launches from many manufacturers, including Tesla’s iconic-looking pick-up truck. Five years from now, one in four new cars sold is expected to be fully electric.1 That, in turn, will fuel demand for batteries and semi-conductors. Automation is the other key tech shift in the car industry. While fully automous vehicles are still largely the stuff of science fiction, the latest models are offering ever more advanced automation features, backed by ever more complex software. China’s Baidu is even planning to launch a car with a detachable steering wheel. According to Goldman Sachs, the average length of software code per vehicle has doubled to 200 million lines in 2020, and is forecast to reach as high as 650 million lines by 2025, presenting a big growth opportunity for the tech sector.2
3. Computing at the edge
The rise of 5G and advances in AI have opened up a new era of data storage. Edge computing uses augmented reality and machine learning to analyse data at or near the place where it is gathered, or “on the edge”. It then takes advantage of super-fast transfers made possible by 5G to send that data to the cloud. When 6G comes, the process will be even faster. One of the key benefits of such an approach is low latency, which in turn opens the door to the development of new devices and applications which rely on minimal delays. Farms, for example, are starting to embrace edge-enabled ground and air sensors to monitor water and chemicals for optimal crop yields. Edge technology can benefit the environment, as it has lower carbon footprint compared to processing data on the cloud. It also creates new cybersecurity challenges and demand for solutions to address them.
4. Power of the circle
From metals and fossil fuels, to animals and crops, we are consuming a year’s worth of the Earth’s resources in just eight months, which is clearly not sustainable in the long run. The answer is to make the most of what we’ve got and make it last for as long as possible. The circular economy concept ideally envisages a world without waste – a loop whereby resources are used and reused for as long as possible. The emphasis is on creating products that are long-lasting and easy to take apart, repair, refurbish and re-assemble to make other products. The approach also involves making greater use of organic materials (such as wood in construction) that are part of a natural loop. Circular design can be applied both to consumer goods and to industry, and it’s a huge opportunity – the circular economy could unlock up to USD4.5 trillion of additional economic output, according to Accenture.3 Governments are increasingly on board. Circular economy is a key part of Europe’s Green Deal initiative, with targets for 2023 including legislation for substantiating green claims made by companies and measures to reduce the impact of microplastic pollution on the environment.4
5. Drug engineering
Drug development is notoriously slow and costly, with low chances of success. But that may be all about to change thanks to advanced computing. In one of the most exciting recent developments in the healthcare industry, DeepMind, Alphabet’s AI unit, succeeded in developing technology that can be used to predict the shape of any protein in the human body. The breakthrough potentially paves the way for much faster, cheaper and more efficient drug discovery – something Alphabet and others are now working on. Over the next decade, the market could be worth some USD50 billion, according to Morgan Stanley. 5
6. Battle against obesity
The prevalence of obesity in the world has tripled since 1975,6 and it is now responsible for some 3 million deaths a year. Covid increased awareness of how excess weight can make people susceptible to other diseases. There is growing momentum – from governments and individuals – to tackle the problem, which coincides with the development of new treatments. One potentially promising new weight loss drug has recently been approved for use in the US; another one is expected to get the green light in 2023. The global obesity treatment market could top USD54 billion by 2030 from just USD2.4 billion in 2022, according to Morgan Stanley. Insurers are slowly becoming more willing to cover obesity treatment, and there is also a growing appetite from the public to pay out of pocket where such coverage is not available.
7. Learning for life
Demographic and technological change have deeply impacted society. As a result, learning is no longer the mainstay of school. A growing number of countries are embracing lifelong learning as a means to cope with the challenges associated with longer-living populations. The pandemic prompted many people to reconsider their lives and their jobs. Labour shortages in some industries have created opportunities for new workers to step in. At the same time, improved work/life balances – with working from home saving commuting hours – have opened the door for people to take up new hobbies. Growing acceptance of online learning has made studying more accessible. It shouldn’t be a surprise that 2023 has been pronounced the “European Year of Skills”, with extra investment in training and a drive to get more women into science and technology.
Opinion written by Stephen Freedman, Head of Research and Sustainability for Pictet Asset Management’s Thematic Equities as well as Chair of the Thematic Advisory Boards
Historically, Japan has been a difficult market for many overseas investors to fully comprehend, with several misconceptions about the Japanese corporate sectors. This offers compelling opportunities for active managers such as Nomura Asset Management to add value through their proprietary research, market insights and company engagement.
Nomura Asset Management will host the “Rediscovering Japan” virtual conference on January the 26th , where you will learn more about the current opportunities from our experts, and hear market insights from the guest speaker Seiji Kihara, Member of the House of Representatives.
Yuichi Murao, CFA, Senior Managing Director and Chief Investment Officer, Equities, will open the event with the Bank of Japan’s monetary policy outlook and the impact on exchange rates.
Andrew McCagg, Senior Client Portfolio Manager, will present the “Japanese Equity Market Outlook for 2023”.
Seiji Kihara, member of the House of Representatives and deputy Chief Cabinet Secretary, will speak on “Towards Realizing a New Form of Capitalism”. Kihara also serves as special advisor to the Prime Minister for National Security Affairs.
New year, same risks? The global economy continues to face challenges – not least weak growth and tightening monetary conditions – and for this reason we have chosen to retain a defensive stance; we remain underweight equities and overweight bonds.
That said, there are encouraging developments in emerging markets.
China’s unexpectedly rapid exit from its zero-Covid policy is likely to result in a strong acceleration in growth towards the end of this year. This, coupled with a weakening US dollar and emerging market assets’ attractive valuations, should help boost the appeal of emerging market stocks and bonds over the medium term. We have consequently upgraded China and the rest of emerging markets to overweight.
Our business cycle indicators show that the deterioration in global economic conditions is gathering pace. A recession will be unavoidable this year, but it should be both shallow and short before the economy begins to recover in the middle of 2023.
Global inflation is likely to decline this year to 5.2 per cent from 7.7 per cent in 2023, helped by weaker commodity prices and falling wage demands and rental prices.
In the US, the high level of excess household savings should support consumption and help the economy avoid a sharp contraction; we expect the US to register real growth of 0.4 per cent this year.
We also think the risk of a deep recession in the euro zone has somewhat receded. Despite weak economic activity and tighter lending standards, industrial production remains resilient.
Falling energy prices, meanwhile, should lead to a significant decline in price pressures across the region, with core inflation more than halving to 1.6 per cent from a 2022 peak.
Japan’s economy, meanwhile, is likely to outperform the rest of the world next year, supported by improving leading indicators, booming tourism and resilient capital spending.
That said, weak retail sales and consumer morale and a rapid deterioration in the current account balance – which is now negative for the first time since 2014 – point to a weak recovery in the coming months.
China’s recent economic data has been weak across the board, but the recent reopening of its economy suggests plenty of scope for recovery, especially for retail sales, which are currently some 22 per cent below their long-term trend on a real basis.
Beijing is likely to adopt a more pro-growth economic agenda, which should help lift growth in the world’s second largest economy to 5 per cent in 2023 from last year’s 3 per cent, according to our calculations.
Our liquidity indicators support the case for retaining a cautious stance on risky assets over the near term. But conditions will likely improve after the first quarter of 2023, especially in emerging economies.
We expect the global economy to experience a net liquidity drain equivalent to 6 per cent of GDP in 2023 as central banks including the US Federal Reserve and European Central Bank continue to tighten the monetary reins. Investors should however expect a shift in monetary tightening trends.
The Fed is, we believe, entering the final phases of its tightening campaign with the benchmark cost of borrowing set to peak at 4.75-5 per cent in the first quarter of this year. The ECB’s balance sheet contraction, meanwhile, is likely to be more aggressive than the Fed’s, amounting to a reduction of some EUR1.5 trillion, or 11 per cent of GDP, which should add to downward pressure on the dollar.
After a hawkish statement in December, investors now expect euro zone interest rates to rise to 3.25 per cent by September 2023.
The Bank of Japan’s surprise change to its bond yield control policy – it will now allow the 10-year bond yield to move 50 basis points either side of its zero rate target – should pave the way for the central bank’s eventual exit from its zero interest rate policy.
Bucking the global trend, China is leading a moderate easing cycle with the People’s Bank of China delivering targeted support measures.
The credit impulse – a leading economic indicator – is positive while China’s real money supply (M2) is expanding at 12 per cent year on year, the highest in six years. In contrast, developed economies continue to experience tighter conditions.
Our valuation model shows bonds and equities are both trading at fair value.
Valuations for global bonds are neutral for the first time since February, with yields 50 basis points lower than their peak in mid-October.
Global equities, meanwhile, trade at a 12-month price earnings ratio of 15 times, in line with our expectations, but our models point to mid-single digit re-rating of multiples over the next year provided that US inflation-adjusted 10-year bond yields fall to 1 per cent.
Corporate earnings momentum remains weak across the world and we forecast 2023 global EPS growth to be flat, which is below consensus forecasts of around 3 per cent growth, with significant downside risks in earnings in case of weaker than expected economic growth.
Our technicaland sentiment indicators remain neutral for equities with seasonal factors no longer supporting the asset class.
Data shows equity funds experienced outflows of USD17 billion in the past four weeks. Emerging market hard currency and corporate bonds posted consecutive weekly inflows for the first time since August.
Opinion written by Luca Paolini, Pictet Asset Management’s Chief Strategist
Professional investors joke that the UK is turning into an emerging market (EM). This is a disservice to actual EM economies. In fact, in some respects less developed countries are proving a relative haven of stability – not least in the corporate bond market.
Broadly speaking, EM corporate borrowers are less vulnerable to capital flight than in the past due to greater local investor ownership of their bonds, have relatively low leverage and are by and large based in countries with robust macro-economic fundamentals. And at a time of general bond market volatility, yields on short duration EM corporate credit look particularly attractive (see Fig. 1).
Of course there is plenty of variation between regions and sectors, so investors need to be diligent in analysing corporate nitty gritty as well as having good understanding of the macro-economic picture. But such efforts are likely to be well rewarded: in many cases, EM corporate bonds are cheap compared with their fundamentals, such as, for instance, the yield spread they offer relative to leverage.
Fundamental attractions
EM companies have done exceptionally well so far in 2022, with revenues up 22 per cent and earnings up 27 per cent during the second quarter on the same period a year earlier. At the same time, their balance sheets are looking healthy, with net debt down 7 per cent year-on-year in the second quarter. This has helped reduce the net leverage ratio to some 1.2 times from 1.3 times in 2021 (excluding Russia and Ukraine for obvious reasons and real estate), according to JP Morgan research.
Many EM companies have built up their profit margins in the wake of the pandemic. This, in turn, leaves them better able to absorb among other things, higher costs from commodity price inflation. Take steel companies in India. The sector has been one of the hardest hit from rising input costs and more recently export taxes. Yet, due to their post-pandemic profit surge, domestic operators have been able to absorb a reduction of 6 percentage points in profit margins to a 12–month average of 21 per cent in Q1 versus a peak of 27 per cent last year.
For credit investors, this still represents a good margin of safety. Furthermore, while these rising input costs might prompt a tick up in leverage, large Indian steel makers have also been on a deleveraging trend for the past few years. Similarly, most other commodity exporters have been doing well.
Meanwhile, many retail-focused companies and those with premium products are in a strong position to maintain pricing power and thus keep up with inflation. In China, large and highly rated tech companies have maintained strong margins as their ultimate customers are to a good extent retail, as well as to the fact that inflation has been running at a considerably lower rate in China than elsewhere. Signals from central government that its regulatory clampdown has come to an end has also helped. At the same time, US restrictions on Chinese tech is having limited impact, restricted to chipmakers.
At the other end of the spectrum there are industries in which rapidly rising costs cannot immediately be passed on to customers and where there is no natural hedge against foreign exchange volatility, such as telecoms. We generally like the sector for its defensive characteristics and predictability of cash flow. But where companies have issued longer tenured contracts for instance for broadband, this means no opportunity to raise pricing for existing customers in the near-term.
What’s more, the more generic the product, the harder it is for companies to pass on costs. And some sectors have been heavily exposed to the energy shock – those utility companies not fortunate enough to be extracting oil or natural gas are feeling the pinch. This is especially the case for utility companies selling to retail customers, not least where governments have been keen to stem inflationary pressures by limiting how much costs are passed through to households.
Prudent financial policies and balance sheet deleveraging in the past five to 10 years have helped most EM corporations across Europe, Africa and the Middle East to prepare themselves for current financial market disruptions.
The wider good health of the EM corporate universe is reflected in its default rates. Strip out Russia, the Ukraine and Chinese real estate and the default rate is a mere 1.2 per cent year-to-date.
Sticking closer to home
EM corporations are also benefiting from increasingly mature domestic financial markets. Being less reliant on foreign sources of capital means that investment programmes are less prone to the whims of global finance and therefore can be more stable than in the past – domestic sources of finance also tend to be stickier. As these countries have grown richer, their banking sectors have become better able to service increasingly sophisticated domestic savers. Furthermore, domestic banking sector balance sheets have been built up in the wake of the Covid pandemic and thus enabled banks to extend credit actively again.
As such, companies in Indonesia, the Philippines and India in particular have increasingly been buying back their outstanding dollar denominated debt and refinanced through cheaper bank loans priced in local currency. That shift is being accelerated by the US dollar’s appreciation and rising US interest rates – increasing the cost of dollar funding – and the cost of these liabilities has helped push companies toward domestic lenders. So, for instance, Indian banks, supported by strong and improving credit quality, have been happy to extend credit and as a result their loan books have grown at a rate of some 12-15 per cent through the first half of 2022 (see Fig. 2).
And with many EM central banks either well ahead of developed market peers in tightening monetary policy or not needing to act as forcefully in combating inflation, funding rates there are likely to grow less significantly than they are for dollar borrowers – though determining the balance of effects here needs good macro analysis on the part of investors.
A good place to start
Seasoned investors know that entry points matter. As with other asset classes, EM debt has been battered during the past year. Overall, there was USD62 billion in cumulative outflows by September, though there were signs that this was stabilising, with around a quarter of that likely to have been in credit products.
Spreads over US Treasury bonds are generous – at 400 basis points against a ten-year average of 315 basis points. And given that Treasury bond yields are themselves at highs not seen in a decade, actual EM corporate yields are at levels not seen in years – 8.3 per cent, last seen in August 2009.1
With lower demand and market volatility, gross supply of EM corporate debt has slumped to USD196 billion so far in 2022 (as per end Sept), against around USD450 billion during the same period in 2021 (see Fig. 3). However, EM companies are relatively well insulated against current fixed income market gyrations. Many firms took advantage of historically low rates during recent years to extend the maturity of their debt, so there’s little in terms of a near-term financing wall, especially in high yield EM, where only USD85 billion comes due in 2023, USD95 billion in 2024 and USD100 billion in the following year.
Times of market stress create opportunities for investors who can pick out the diamonds from the shattered glass. There are plenty of these in the EM corporate universe, where investors are increasingly well compensated for taking on risk with yields that haven’t been seen in many years generated by high quality, well-run companies.
Opinion written by Sabrina Jacobs, Pictet Asset Management’s Senior Client Portfolio Manager
Luca Paolini, Pictet Asset Management's Chief Strategist, and Arun Sai, Pictet Asset Management's Senior Multi Asset Strategist
2023 will be a year when the investment environment slowly gets back to normality. Inflation will come down – even if not quite as fast as the market seems to expect. Economies will struggle for growth, but manage to stave off a deep downturn.
Equities are set to tread water, but fundamentals will suit high quality bonds. Meanwhile, emerging market assets, particularly local currency debt, are set to shine amid a weakening dollar and a revival in the Chinese economy.
The global slowdown – a number of indicators suggest various leading economies might already be in recession – has been the most anticipated one in living memory. Central banks have responded to this year’s surge in inflation by putting on the brakes, and that’s filtering through to their economies. As a result, global annualised quarterly real GDP growth is set to run at below potential through to at least the final three months of 2023 (see Fig. 1).
But at the same time, the slowdown is likely to be less painful than past recessions. Corporate and household balance sheets are healthy, both still have excess savings built up during the Covid crisis, particularly in the US. This has allowed them to absorb some of the impact of inflation, while at the same time banks have continued to lend. Nominal growth, which is key to economies’ resilience, has been running at some 10 per cent, largely on the back of very high inflation. So, unlike during the global financial crisis of 2008, this time there is no sign of a looming debt crisis in any of these economic segments.
An inflationary hurdle
Inflation will remain a hurdle, but it won’t be the market’s primary driver during the coming year (see Fig. 2). While there are signs it has already peaked in most major economies, we think investors are too optimistic about how fast inflation is likely to fall. The jobs market especially in the US remains strong, supporting wages. And components such as rents, which are a sizeable proportion of the consumption basket, are slow moving, taking longer to normalise.
We also believe central banks will be cautious about entering into a new easing cycle – certainly, they won’t make the switch anywhere near as quickly as the market expects. In part that’s because central bankers are particularly sensitive to the risks of cutting rates before inflation has been fully suppressed. To do so would risk another, even less controllable surge in inflation, which would shatter their credibility and force even more drastic efforts to get back to price stability. We don’t think they will start to ease policy until 2024.
Direction of travel is key
What matters most for markets, however, is that official rates will have stopped rising. The end of monetary tightening will be greeted with relief, giving a lift to high quality debt – both sovereign bonds and investment grade credit. Shorter maturity debt is likely to benefit first, with bonds further along the yield curve showing more modest gains amid expectations of an economic revival. Investors should be more cautious about higher yielding debt, with the economic downturn is set to push up default rates.
And once rates peak, equities should start to benefit from improving valuation multiples offsetting weaker earnings – though that’s more a story for the second half of the year.
With the US further along its tightening cycle than other major central banks, a peak in US rates is likely to put downward pressure on the dollar. The greenback is already considerably overvalued and its long-term fundamentals are poor – a currency’s long-term value is determined by fiscal discipline and productivity growth and the US scores badly on both counts.
A weakening dollar will be beneficial to emerging market assets, particularly emerging market local currency debt, which we see as a bright spot on the investment landscape, not just during the coming year but for some time to come. Further support for emerging market bonds and stocks is set to come from China’s economic revival. We think that the government will have to respond to recent protest against its draconian zero-Covid policy by relaxing restrictions. At the same time, it has been offering some support to the country’s vital but beleaguered real estate sector. Together, we think these effects will underpin growth of some 5 per cent over the coming year. Healthier Chinese growth will also benefit other emerging Asian economies.
In a nutshell, 2023 will be a year of caution for investors. But after a miserable 2022, when virtually all asset classes suffered drawdowns (with the notable exception of energy), there will also be reasons for cautious optimism.
Opinion written by Luca Paolini, Pictet Asset Management’s Chief Strategist, and Arun Sai, Pictet Asset Management’s Senior Multi Asset Strategist
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