Rates, spreads, inflation recession, liquidity, technicals and fundamentals

Moderated by Jonas Wäingelin, NordicInvestor; Text by Hamlin Lovell, NordicInvestor 

In 2023, asset owners, asset managers and allocators face a new landscape of absolute and relative value and risk premia in terms of interest rates, credit spreads, illiquidity premia, corporate and consumer default risk. For this discussion we were joined by three, from Norway, Sweden and the Netherlands, to hear how they are adapting to the brave new world. The video from the discussion is available below as well as written a summary.

Panelists:

  • Jonas Thulin is Head of Asset Management at Erik Penser Bank, a small privately owned private bank in Sweden, investing in everything everywhere to beat indices and generate good risk-adjusted returns. He advises on all sorts of asset allocation and portfolio construction for various client mandates, and makes extensive use of ETFs for strategic and tactical asset allocation, with an average holding period of 6 months.
  • Thor Abrahamsen is Senior Investment Executive at Norway’s Gard, the world’s largest maritime insurer, which invests across most asset classes apart from private equity, and in common with most insurers has a high weighting in fixed income. The portfolio is mainly US Dollar based but it can invest in other currencies including Euro.
  • Egbert Bronsema is a Senior Portfolio Manager in Alternative Fixed Income at Aegon Asset Management. His focus is on consumer, mortgage and asset-backed securities, across the capital structure, mainly in Europe, for various funds and mandates.

Long term and short term views on illiquid credit

In the era of zero and negative interest rates, some investors were forced to move out of traditional fixed income and into in private credit to meet their minimum return targets. In 2023 there are more choices in liquid, semi-liquid or illiquid credit, and listed corporate debt has made a very strong start to the year.

Some allocators maintain a balance between the two:

“Illiquid credit is worth allocating to, but is now a very different value proposition than two years ago, now that rates are no longer zero. When rates were zero it was attractive to get up to 10% on private credit. In relatively low risk lending the choice was between 2% to governments and 8% to private credit but now the gap is not so wide. And with higher yields on cash I can afford to be patient. We can now earn reasonable yields in liquid investment grade credit rather than being forced into less liquid alternatives,” says Abrahamsen.

Longer term investors need to carefully weigh up risks and reward. “For investors who do not need the liquidity, private credit still offers long run advantages where the managers do well, although the advantages tend not to be as great as managers hope. There are a lot of risks in private credit that are not always being considered,” Abrahamsen adds.

In 2022, many private debt strategies appear to have been completely immune from the spread widening seen in public credit markets, but in some cases, this may be a function of valuation frequency: “Liquid credit will take an immediate price hit from information and emotions in the market, but more irregular pricing means it can take more time for private credit. The problem arises if investors in private all want their money back. Then there will be a price but it may be much lower.” explains Abrahamsen further.

Meanwhile other investors are more clearly finding liquid credit more attractive: “The appetite for illiquid credit varies between client mandates and buckets. If we promise daily liquidity that puts limits on what we can do. In other mandates investors are locked in. But we generally do not have too much in illiquids anyway. We would rather trade around market trends, and use credit more like equities. After a good start to 2023 for liquid credit we expect more inflows into liquids and less into illiquids,” says Thulin.

In other cases the decision is more about the type of mandate being managed but there are opportunities for attractive yields across the liquidity spectrum:  “the size of illiquid credit allocations depends on the investment horizon. Investors who need monthly liquidity should go for more liquid products and they can still earn some pickup. Even in semi-private or public debt there is no need to give up any yield,” says Bronsema.

Many private credit strategies tend to be more concentrated and focused than public credit strategies, and might therefore avoid broader credit market trends. “Private credit can diversify away from general credit market risk more easily,” argues Bronsema. “Private credit also helps you to focus on ESG,” he adds.

Addressing recession risk

“Some investors may sell out of private credit due to short term recession fears, even if it might still be attractive in the long run,” says Bronsema.

There are different opinions about recession. Some economists insist that an inverted US yield curve and the delayed impact of rate rises must eventually feed into a recession. Others have a more sanguine outlook, and point to strong US jobs data and other economic data released in early 2023.

Bronsema does not view recession risk as a big threat to his markets: “If you assume a recession is coming up, there will be some limit to how high unemployment could go. Consumers are in better shape overall. Mortgage rates are higher than the past few years, but are still historically low, in early 1980s in the Netherlands they were 11-12%”.

Abrahamsen also expects that consumers should weather a recession well, not least because their wages will hold up: “It is not the 1970s. The job market will be tighter because of demographics. There are less workers and less babies and workers do not have the right skills. Recession may be different from what we have seen in history. Affordability levels should be okay for existing US mortgages, as they are mostly fixed rate”.

Thulin, who has developed his own proprietary methods of analysing economic data, does not expect any recession. He has been in the bullish camp since mid 2022: “Our bullish business cycle view is not the consensus view. Based on the data and earnings revisions, we think the trough in earnings is behind us, in the US, Europe and Sweden for example. We are now fully loaded on risk assets since June 2022. We switched from US equities to 25% overweight European equities in November 2022, and have been invested in emerging market and global credit for some time, in various currencies and structures, rather than less liquid Swedish corporate bonds and high yield. Sweden can trade like a banana republic! Last year the whole market was convinced about recession but we did not see it in our nowcasting data. Some recession risk is already priced in, even though recession never happened in the fourth quarter of 2022 and we do not see it in the first quarter of 2023 either. There is still plenty of cash on the sidelines which could be invested into equity markets, which have had the best start to the year for two decades”

Thulin is happy with equity and bond market risk: “we bought US Treasuries at yield 4.2 %. We are happy to trade in line with falling yields”. In contrast, Abrahamsen does not want to invest further out than two year US Treasuries, and Bronsema is maintaining a short duration bias.

In common with Thulin, Abrahamsen also likes some emerging markets, but he is somewhat more selective and cautious in choice of equity sectors: “Valuations in equities and credit do not fully reflect the risk. Stocks that did best this year is all the trash from last year that rely on private investors and private equity to raise more capital.  But someone has to pay the bill somewhere. In equities we like energy, mining and materials, and healthcare. We also like gold and precious metals, but are not too exposed to long duration growth stocks such as technology. We are somewhat defensive but are not in the bunker,” points out Abrahamsen.

Consumer or corporate debt?

For other investors, recession risks and the interest rate climate are more about guiding duration and choices of credit asset classes and sub-asset classes. Bronsema is keeping duration short: “we don’t have a crystal ball. A recession has been partly priced in. But the market can also be very wrong about interest rates. Inflation has come down but is still quite elevated globally. I would still have a short duration focus”.

He also has a preference for consumer over corporate risk: “Inflation is still high and companies may not be able to pass all costs onto consumers. In general consumers have extended their duration at lower rates for longer periods. In the Dutch market the average mortgage has gone from a 7 year to a 15 year fix . So financing costs are still low even if market interest rates are higher. The consumer is in better shape than corporate markets”.

Bronsema has also noticed that the climate could be improving for strategies based on fundamental analysis: The last 10 years was purely technical with no credit cycle and fundamentals did not really matter. The last year has seen the market realizing there were fundamentals”. This sort of fundamental analysis could for example focus on differences between countries. “For instance, UK mortgages tend to only fix rates for 5-6 years but in the Netherlands rates can be fixed for much longer – and many borrowers can keep the same mortgage when they move house”.

Abrahamsen is also somewhat cautious on corporate high yield: “corporate high yield headline spreads are roughly back to pre-pandemic levels, but most of the increase in absolute yields has come from interest rates not credit spreads. The credit cycle, which disappeared for 10 years must come back at some stage. Even if defaults have been delayed, the risk has not disappeared and might come back in 24 months when they need to refinance”. Bronsema broadly agrees on the possible timeframes: “companies also pushed tenors out to 2025 so a maturity refinancing wall is not imminent”.

Tactical trading, inflation and rates

Abrahamsen sees disconnects between financial markets and the real economy. “Momentum and flows are there in financial markets. But in the real economy energy costs have jumped 100-200%, and there are structural inefficiencies and problems in European energy markets across the world. That also feeds into higher food prices”.

Thulin does not agree since he is confident about using the fundamental economic data to forecast financial markets: “Our macro data analysis does not raise concerns. We see markets reducing the probability of recession in Germany and we trade on that. However our view is short term opportunistic and not necessarily a full 2023 outlook. It could end up as a horrible train wreck. In terms of QE and QT we look back at 2018-2019 and work out why QT failed. Banks had to finance themselves on 9% overnight. That history informs our analysis of QT today. They have learned from 2019 and the system is very well functioning for now. If we saw the liquidity situation deteriorating, we would end up being underweight equities this year. We are certain we can keep an eye on it”. Thulin is confident, and relies on the same framework that predicted the IT crash, financial bubble and caught the rebound in the Pandemic.

Abrahamsen is more skeptical about how far and fast disinflation can go: “Inflation is certainly falling but the question is when and where it stops falling. There is a lot of optimism that rates come down.  We are not sure that central banks can quickly and magically fine tune inflation back down to 2% for the first time in history, with interest rates at higher levels than before. This seems too easy and rates are not going back to zero. We are entering a different environment and will not go back to the same markets”.

There are certainly tactical trading opportunities “Everyone is looking at high frequency data, but we are in a much more volatile world, and a lot of short term price movement does not reflect fundamentals,” says Abrahamsen. “Cash is a valid allocation. It always has been. Now you can be more tactical, move in and move out. It is a better environment to invest in. The volatility is going to be significant. It’s a much more interesting environment to be an investor”.

Indeed, some trading-oriented investment strategies may even benefit from higher rates. “Higher interest rates are positive for hedge funds. Post 2008, zero rates on cash killed hedge fund returns and forced them to trade more and being in the market at all times means taking more risk. Now many can earn 4-5% on their cash, on top of their trading. This is a completely different world to the past 10-12 years,” says Abrahamsen. Hedge funds can sit on a lot of cash partly because they use derivatives and also because in market neutral strategies the short book proceeds effectively finance the long book.

For Bronsema, the trading decision once again returns to differences between investor mandates:. “If you have a long term view, the data does not matter. In the short term it is important to be able to shift to low duration. Some investors want more duration while others want more defensive positioning”.