This week’s relative calm in equity and bond markets is in stark contrast with last month’s turbulence. Investors appear to have put concerns over the war in Ukraine on hold for a while. Some market experts warn however that “sentiment may be too positive”. Illiquid corporate bonds are seen as a safe haven.
The economic consequences of Russia’s invasion of Ukraine gave both equities and bonds a volatile first quarter. Nevertheless, most of the losses incurred were quickly recouped.
The leading MSCI All Country World Index is now back above its pre-war level. The Vix index - a measure of volatility - has fallen below its long-term average. The Fear-and-Greed index stood at a neutral position of 52 points on Tuesday afternoon. A month ago, it indicated “extreme fear” with a score of 17 points.
Too much optimism in equities
Volatility in the markets is usually short-lived. Nevertheless, according to some specialists, the likelihood of a prolonged market downturn now seems to be increasing. Nathan Sheets, Citigroup’s chief economist, told Bloomberg that the chance of a global recession in the short term is considerable, “perhaps 30 percent”.
Chris Iggo, CIO at AXA IM Core, also warned against too much optimism. Corporate earnings projections do not take sufficient account of the increased risk of recession as a result of the war in Ukraine.
And the effect of central banks’ tightening policies is usually delayed, which means that earnings per share expectations can still be revised downwards, Iggo said.
Positive on bonds
Equity markets have recently reacted positively to the peace talks between Russia and Ukraine, but have yet to deal with higher bond yields, monetary tightening and earnings revisions, Iggo said.
On bonds, he said he is positive. With all the uncertainty in the market, interest rates have risen significantly and credit spreads have widened. If the market is correct in terms of pricing in interest rate increases, it puts an upper limit on the room for interest rate increases, he said.
AXA IM sees ten-year treasury yields peaking at 2.5 to 3.0 percent this cycle. “Given what is already priced in, we may be close to some interesting levels,” Iggo said.
Corporate bond markets in particular are in good shape, he said. The widening of credit spreads suggests to us that corporate bond yields - both of investment grade and high yield quality - may be superior to government bond yields.
Recession possible, but not likely
According to JP Morgan, markets are rightly calm at the moment. Recession risks have certainly increased, but the bank’s base case remains that balance sheets are strong enough to prevent it, according to its global outlook for Q2.
Inflation, on the other hand, is proving more persistent than expected, and the impact of the war in Ukraine on commodity prices is a significant risk across the capital markets.
Slower growth and higher inflation, matched with consistent policy tightening, are a recipe for volatility as asset prices adjust to the new environment, said John Bilton, head of multi-asset strategy at JP Morgan.
JP Morgan says it is limiting its risk appetite by reducing its equity overweight to neutral and shifting its regional preference back to the US. The bank is maintaining its modest underweight in duration, “given the Fed’s continued hawkish tone,” Bilton said.
Illiquid corporates as safe haven
If pessimists are right on equity markets being overpriced, and investors look for shelter, the question is where to look for safe havens.
Richard Abma, CEO at OHV Asset Management in the Netherlands, sees that loans with a government guarantee are currently very popular as a safe haven with institutional investors.
This niche market is regarded as a way for pension funds and insurers to fill in the illiquid part of the investment portfolio and, depending on the maturity, offers a premium of about 100 to 150 basis points over interest rates on Dutch government bonds. Usually, the loans are linear and run for two to sometimes even ten years.
Abma: “This usually concerns financing of Dutch export products insured by Atradius Dutch State Business. Think, for example, of an MRI scanner sold by Philips to a developing country where an irrevocable Dutch State guarantee is issued for the repayments and interest.”
Investing in highly creditworthy loans that repay regularly during the term provides the opportunity to reinvest at higher interest rates, said Abma. “Within our own fixed-income fund Fresh Fixed Income Fund we invest about 20 percent in this type of loans and we apply a short duration of one and a half years throughout the fund. The objective is a net return of 2.5 percent on an annual basis with an average investment grade risk profile,” he said.
This article originally was published in Dutch on InvestmentOfficer.nl
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