Has the banking crisis changed the outlook for fixed income?

Although investors face challenges this year, opportunities remain in emerging markets, ESG and private credit

Switzerland's Credit Suisse was sold to UBS Group in an emergency rescue last month. Bloomberg

The recent collapse of Silicon Valley Bank and the subsequent acquisition of Credit Suisse by UBS have triggered concerns about contagion within the broader financial sector and raised questions about global monetary policy.

Central banks now face the challenge of maintaining financial stability while also controlling inflation amid heightened geopolitical uncertainty and the looming threat of a global recession.

This convergence of adverse factors has created an atypical situation for investors.

In 2022, traditionally defensive fixed-income assets such as government bonds and investment-grade credit failed to provide the expected performance during economic contractions. Stocks did not fare any better.

However, recent market trends suggest a potential shift towards a recovery regime, with riskier assets such as high-yield credit performing better. Nonetheless, much depends on the future trajectory of interest rates.

Market participants currently expect a peak in interest rates by mid-2023, with inflation expected to decline and the US Federal Reserve nearing the end of its fiscal tightening.

However, caution is warranted, given that on April 3, Opec and its allies, including Russia, decided to cut crude production by a combined 3.6 per cent of global demand. If high inflation persists, central banks may not hesitate to reduce rates.

The danger is that a prolonged period of high inflation and the resulting central bank response of higher interest rates could lead to an economic slowdown.

This would lead to a further deceleration of the global economy and a continued contraction regime in the coming months, with below-trend growth and a risk of a recession.

Despite these challenges, we believe there are opportunities for investors to find returns in fixed income.

Throughout the current contraction regime, we have adopted a more defensive stance while still recognising opportunities for investors in investment-grade debt and high yield.

Despite the challenges faced by fixed-income assets last year, the higher bond yields, weaker economies and central banks halting rate increases may render 2023 a more favourable year.

The case for high yield and investment-grade credit

It is important to note that US credit spreads widened towards historical norms last year. Even though they remain short of those benchmarks, there is the potential for credit spreads to widen further if economies weaken.

However, we note a recent narrowing as markets start to look forward to an end to central bank tightening and an eventual economic recovery.

Even if we allow for a slight widening of those spreads, our projections suggest that total returns on credit will be higher than that on government debt in 2023.

EM fixed-income assets gain traction

Emerging market (EM) fixed-income assets appear more attractive than their developed market (DM) counterparts, based on the assumption of narrowing spreads. Additionally, we expect that local currency versions of EM debt will outperform hard currency versions, albeit with more volatility, as the US dollar weakens this year.

The Russia-Ukraine conflict has significantly affected the energy mix for European countries, forcing governments to prioritise energy resilience over energy transition in the short term. This has led to a strong performance for oil and gas stocks in 2022.

If Opec and its allies continue to pursue a hawkish approach to cutting production, such stocks will continue to perform well into the medium term.

Fixed income and ESG: The opportunities

Fixed-income and environmental, social and governance (ESG) investments are poised for growth this year — for two reasons.

First, fixed income allows exposure to both countries and corporates, enabling active managers to direct capital to sovereigns with strong environmental policies.

Second, the market is registering increased interest in fixed ESG index exposures, as current offerings are predominantly equity-focused.

Private credit remains a robust option

Private credit remains a robust option for portfolio diversification, offering enhanced income due to exposure to additional credit and liquidity risk. Additionally, private markets provide uncorrelated returns compared to traditional listed equities and bonds, contributing to strong and differentiated income while reducing volatility.

We believe that central banks will not wait for inflation to reach target levels before ceasing rate increases. They will probably require evidence that inflation is trending downwards.

Market-implied rates indicate that major central bank rates may peak in mid-2023, with possible rate cuts by year-end. This further supports a continued weakening of the US dollar throughout 2023.

Geopolitics may pose risk to financial markets

Geopolitical events, such as the Russia-Ukraine conflict, have contributed to a widening of risk premiums across financial assets.

In 2023, stalemates between US political parties and between Russia and Ukraine may continue to dominate the geopolitical landscape, with China-US tension remaining prominent.

Meanwhile, across Europe, polls are indicating that a series of elections could result in Spain shifting towards the centre-right, while Turkey's President Recep Tayyip Erdogan could be defeated in this year’s presidential elections.

While there are local elections across the UK that are expected to serve as a warning for Rishi Sunak’s Conservatives, there are no general elections in any of the G7 or Brics nations — comprising Brazil, Russia, India, China and South Africa — in 2023.

The fixed-income outlook for this year will require investors to navigate a turbulent financial landscape carefully. Central banks' responses to inflation, geopolitical tension and the performance of various asset classes will all play a role in shaping investment strategies.

Despite these challenges, opportunities still exist for investors to find returns in fixed income, particularly within emerging markets, ESG investments and private credit. Maintaining a diversified portfolio will be essential to weathering the storms of an uncertain global economy.

Paul Jackson is global head of asset allocation research at Invesco

The Federal Reserve building in Washington. Market participants expect a peak in interest rates by mid-2023, with inflation set to decline while the Fed approaches the end of its fiscal tightening. Reuters