15 Jul 2022
Webcast | Tim Foster | Global
Portfolio manager Tim Foster takes stock of what has been a very challenging period for fixed income investors. He discusses how the market environment is likely to evolve over the coming months and outlines how the portfolio is positioned to capitalise on the pockets of value emerging across rates and credit markets.
The ideas and conclusions here do not necessarily reflect the views of Fidelity’s portfolio managers and are for general interest only. The value of investments can go down as well as up, so your clients may not get back what they invest.
The opening six months of 2022 has been one of the worst periods for fixed income markets in history, with 10-year Treasuries delivering their worst first half return since 1788. But this pain hasn’t been limited to fixed income - the S&P 500 had its worst start to the year in 60 years and delivered negative returns in consecutive quarters for the first time since the global financial crisis.
The combination of both rates and credit markets selling-off at the same time has been particularly challenging for fixed income investors to navigate. Typically, investment grade bonds in particular would offer an element of in-built diversification, but we know from history that these diversification benefits tend to work less well in periods where inflation is above 3%. This is exactly what we’ve seen in the first half of this year.
Against this backdrop, it is unsurprising that portfolio performance has been challenged over recent months, with returns over H1 broadly in line with investment grade corporate bonds. Around three quarters of the losses year-to-date have been attributable to interest rate moves, with credit spread widening responsible for the remaining one-quarter.
Since the middle of June, the market has started to focus less on the stickiness of inflation and slightly more on how central bank tightening will hit economic activity. Our own view is that we will see a significant growth slowdown, with inflation also starting to fall by year-end.
This strikes us as a good point to add further to duration where we have recently taken the opportunity to increase our position by around 1.3 years. Encouragingly, there have also been some tentative signs of a return to negative correlation between rates and equities, which has flipped negative since around mid-June.
In credit, some striking value has been created by the recent sharp moves we’ve seen. Looking back over 20 years of data, we can see that European investment grade credit spreads, for example, are now at the 91st percentile of their historical valuation range.
What continues to be relatively expensive is high yield. European high yield is slightly cheaper than US high yield - unsurprising given Europe’s dependence on imported energy and proximity to the war in Ukraine - but we could still see significant spread widening. US high yield could have even more to give up at current valuations.
Given this, we are treading cautiously as we think credit spreads could move wider on growth concerns, before eventually reversing when it becomes clearer that central banks are willing to move away from their current hawkish stance. Within credit, we prefer investment grade over high yield and have added some exposure in Europe where we think the risk-reward profile is more tilted in our favour.
We’ve been struck by the recent, rapid deterioration in some of the survey data for businesses and consumers in the US and Eurozone. We’ve thought for some time that a recession was relatively likely in the Eurozone, but the timing has come forward and we also now see an increased likelihood of a US recession.
The challenge moving forward is predicting the length and depth of any recession. In this regard, we are concerned that the Fed in particular has signalled it is now consciously following a very data-driven approach to its policy settings. This means that there is a risk that the current rapid pace of hikes could continue long after they are needed, given the lagging nature of labour market and price data.
All in all, this points to more volatility ahead. However, the in-built flexibility of the portfolio should stand us in good stead to navigate what will likely be a slow moving and bumpy crisis. While we remain relatively defensively positioned, the recent weakness in markets has created pockets of value for us to exploit, particularly in European investment grade. We will remain alert to capitalise on further opportunities as they emerge over the coming months.
Important information
This information is for investment professionals only and should not be relied upon by private investors. Past performance is not a reliable indicator of future returns. Investors should note that the views expressed may no longer be current and may have already been acted upon. Changes in currency exchange rates may affect the value of investments in overseas markets. The value of bonds is influenced by movements in interest rates and bond yields. If interest rates and so bond yields rise, bond prices tend to fall, and vice versa. The price of bonds with a longer lifetime until maturity is generally more sensitive to interest rate movements than those with a shorter lifetime to maturity. The risk of default is based on the issuers ability to make interest payments and to repay the loan at maturity. Default risk may therefore vary between government issuers as well as between different corporate issuers. Due to the greater possibility of default, an investment in a corporate bond is generally less secure than an investment in government bonds. Reference in this document to specific securities should not be interpreted as a recommendation to buy or sell these securities and is only included for illustration purposes.