“Markets currently appear to need further sequential evidence before pricing a more sustained period of higher yields.”
The recent downward inflation surprises in the US (October) and Euro area (November) support a downshift to 50bp hikes at this month’s central bank meetings. Fed Chair Powell’s comments that “it makes sense to moderate the pace of our rate increases as we approach the level of restraint that will be sufficient to bring inflation down” fuelled market expectations that the Fed may be close to a pause and has contributed to a repricing in Fed funds futures to implying rate cuts starting in 2H23. However, labour demand remains surprisingly resilient, demonstrated by November US job creation (NFP +263k) and average hourly earnings (+0.6%) exceeding consensus (+200k and +0.3% respectively) while unemployment was unchanged at 3.7%. The combination of labour market resilience with sticky wage inflation shifts risks toward higher-than-anticipated terminal rates for both the Fed and the ECB. Markets currently appear to need further sequential evidence before pricing a more sustained period of higher yields.
Recent US 3Q financial results demonstrated generally positive corporate credit metrics. US investment grade and high yield median net debt to total assets ratios have been almost flat this year. Second, despite the significant increase in bond yields this year, interest expenses as a share of total debt barely moved, reflecting the combined effect of the severe decline in new issue volumes this year in the case of HY issuers, and the long maturity debt profile in the case of IG issuers. Third, there was confirmation that net margins appear to have plateaued among both IG and HY-rated companies. Lastly, and on a more negative note, liquidity positions further reverted to their pre-pandemic levels.
In China, policy support towards the property sector is increasing. The recent array of 16 measures that financial regulators directed to banks show stronger commitment to resolve financing issues. The new policy steps include: 1) State Council support for developer bond issuance, and asked banks to support developer loans and home mortgages; 2) PBOC to provide Rmb200bn interest-free new loan quotas for stalled residential projects to ensure property completion; 3) CBIRC to reasonably distinguish the risks at project level against risks at holding group level, establish a “white list” of quality private developers and arrange development loan extensions for developers with temporary liquidity issues; 4) Six major banks granted total credit lines of Rmb1.275tn to 17 developers; 5) NAFMII accelerated credit support with Rmb93bn medium term notes offering quota granted to select developers. These measures should help break the domino effect that has seen contagion spreading to SOE-backed developers. On top of the loosening of Zero COVID policy which should boost economic activity, liquidity support for near term maturities should ease cash flow strain and reduce occurrence of defaults. More targeted interventions could be rolled out if the sector fails to regain its footing on the back of recent measures.
Since November, Futures Reflect Growing Expectations Of Fed Rate Cuts
Fixed Income Strategy
With economic resilience, market pricing the rate hike cycle pausing and/or terminal rate below 5% may be overdone. Yields may reverse the recent drop, especially if November CPI data shows disinflation is not sustained. Take profits on recent outperformance of long dated bonds and position in the front end and belly. Risks to this strategy: if the soft-landing path no longer looks tenable should data come in worse than expectations, the duration rally would likely resume as recession risk is repriced. Another scenario is a rapid decline of rates volatility encourages further buying of long end bonds.
Position in China property IG as the main beneficiary of policy interventions to date. This segment mostly comprises SOEs and those with mixed ownership, both of which are better supported in terms of onshore funding access and experience smaller decline in sales year-on-year. While China property HY bonds may rebound, HY developers still face strong headwinds as the announced measures are not sufficient to cover liquidity shortfall for weaker developers. This leaves mid-sized and several large developers at risk of credit events.
With China’s domestic GDP expected to rebound from less than 3% in 2022 to 4 – 5% in 2023 with a base case that the economy reopens, that could boost commodities prices – especially base metals but oil too. Position in energy and commodities producers that are less levered and have healthy free cash flow.
While a moderate recession in Europe is likely, both tail risk and macro uncertainty have declined. European IG credit offers significant spread buffer against downside scenarios and looks among the most attractive areas in DM credit.
As 2022 comes to a close, we prefer to raise cash levels in anticipation of lower market liquidity and in turn market volatility. The base case scenario now is that inflation would peak and the effects of multiple rate hikes is beginning to take a toll on the global economy, with terminal rate peaking at 5.00% to 5.25% in mid-2023 and economy starting to enter recessionary mode (or at least a mode of benign growth) in the second half of the year. We anticipate continued volatility under both environments, along with systemic risks that may potentially lead to a risk-off environment during that time.
- In the US, we recommend to Overweight in defensive sectors, particularly in Healthcare and Consumer Stables in view of rising recessionary risks.
- In China, we recommend to overweight in Telecommunication companies, especially those with strong dividend yields for a more enticing risk/return payoff as well as selective Consumer and Airlines, Travel-related sectors that are beneficiaries of the gradual Re-Opening theme.
Overall, we remain biased towards HK/China for several reasons. Heading into 2023, we believe it’s a tale of two “cities” (China vs rest of other major economies) where we anticipate the Chinese economy to stage a recovery on the back of the loosening of strict zero-Covid. These reasons include but are not limited to 1) US economy is showing accelerated signs of slowing down with rising probability of recession; 2) Europe is reeling from a weak economy coupled with high inflation and a low possibility of any kind of resolution of the Ukraine-Russia war in the near-term while the ECB is facing an uphill task trying to fix these issues with limited tools and wiggle room and 3) anticipation of further loosening of strict zero-Covid policies in China/ re-opening theme and further fiscal and policy stimulus from the Central Govt. to keep the economy growing at a targeted 5% for 2023. Separately, an improvement of investor sentiment in the Chinese real estate segment alongside a reversal in dollar strength too should be supportive of China debt in 2023.
In the short term, continue to employ tactical trading to capitalize on volatility and ride on upward-trending themes. The China re-opening theme (e.g., Chinese airlines, F&B Consumer), the early termination of the Fed’s rate hikes and any progress towards a resolution in the Russia-Ukraine conflict can all lead to further rebound in the equities market that might be swift, substantial, and temporary. Nonetheless, these tactical positions ought to be based on quality companies with solid fundamentals rather than speculative positions.
In addition, consider hedging your Equity exposures in the near-term if you haven’t already done so as the recent strong market rally has priced a large extent of the positive catalysts that we mention above, in particular, new Equity exposures, i.e., for every dollar of Equity exposure you put on, hedge with downside protection instruments such as inversely correlated ETFs (E.g. 7300 HK, 7500 HK, PSQ, SQQQ, etc.)
Research – Private Credit
Bond prices have an inverse relationship with interest rates – as global central bank increase interest rates, bond prices will fall. Conventional wisdom to find shelter in bonds as supposed to equities was only met with further losses in the current rising interest rate environment i.e. -10.30% returns between Q3’21 to Q2’22. However, if we look at the Cliffwater Direct Lending Index, a private credit index, we see a significant historical outperformance compared to its fixed income peers whenever interest rate was increased by 75 bps across the last 15 years.
Figure 1: Historical returns after increase in rates of 75bps+
Source: Blackstone, Cliffwater Direct Lending Index (CDLI), data as of 30 June 2022
On an annualised basis, private credit also demonstrates superior risk-adjusted returns compared to its peers and a low correlation to investment grade bonds i.e. -0.32. This highlights the important role of private credit as a means to preserve capital, generate yields and enhance returns from capital appreciation. Above all else, it adds as a source of diversification to a high beta portfolio.
Figure 2: Historically strong risk-returns with low correlation to IG bonds
Source: Blackstone, data as of 30 June 2022, 15-years annualized
Within the private credit space, senior debt remains the most resilient across market cycles due to its floating interest rate structure as compared to distressed credit or mezzanine debt. When interest rate rises, coupons increase to alleviate interest rate risks. Additionally, first lien debt also provides investors first claim on the debt collateral which acts as a downside protection given recessionary risks.
Figure 3: Floating rate senior debt are most resilient in a rising rate environment
Source: Cambridge Associates LLC. (2022)
When selecting private credit investments, we also look at key factors to lower interest rate sensitivity in our risk management process. This includes choosing funds with a high floating rate exposure, shorter duration, higher coupons and wider yield spreads.
Private credit has a saying. We will surely win as long as no one loses, meaning as long as defaults is managed, the returns are somewhat assured.
Figure 4: Key factors in lowering interest rate sensitivity risk management
Source: Oaktree (2022)
Over the last few months, the IA team has conducted our preliminary due diligence meeting with several private credit fund houses including Blackstone, Oaktree, Apollo, etc.
Traditional 60/40 portfolios have unperformed in 2022 against the backdrop of the Ukraine-Russia War, commodity price shocks and hawkish central banks which has led investors to look for opportunities in alternative investments including the private credit space.
Source: Blackstone, Oaktree, Apollo, PineBridge, CIFC (2022)
*Incident of 65% recovery with 10bp actual loss 2015-2017
Among the private credit funds, we prefer BCRED for the following reasons:
- Blackstone is one of the largest global alternative asset managers with a robust credit platform for their deal sourcing.
- BCRED is diversified across more than 500 large-cap companies in high-growth and strong cash flow sectors with additional active risk monitoring
- Strong risk-adjusted returns of 12% YTD in 2021 with an annualised distribution yield of 7.90%, leveraged 1.3x.
- Performance is expected to remain consistent moving into 2023 as 91% of portfolio holdings are senior secured and primarily floating rate loans; well positioned for capital preservation while providing income in a rising rate environment.
- Barrier to entry is relatively lower compared to other funds with a USD50,000 minimum investment sum, 1-year soft lock-up period and is accessible by most major custodian private banks.