Three themes (and what they mean) for income investors

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As markets and global macroeconomic conditions have shifted, we believe that there are three themes income investors may want to examine more closely. Below, we explore these themes and detail the potential investment implications.

1. Beware recession complacency

Divergences in economic activity have remained a dominant theme across markets over the year-to-date period. At the time of writing, North America has shown greater relative economic momentum, but prospects have faltered in Europe and in China. In Europe, we have seen a sharp rise in interest rates drag on economic activity. At the same time, the ongoing weakness in global manufacturing sectors has hit European countries much harder than others given their larger share of industrial exposure. Meanwhile, China has seen a sharp deceleration in activity. Private businesses and consumers seem to lack optimism and are holding back on capital expenditure and purchases. In addition, the recovery in the large residential real estate sector has been very slow.

On the other hand, the recent outperformance of the US economy has been a surprise relative to consensus expectations. In fact, the recent period has seen many economists revise their forecasts for a recession in 2023. This said, there’s much debate around the path forward. At present, our base case is that we’re likely to see a downshift in growth prospects for the region due to weakening consumer credit, falling profit margins and potential future weakness in the labour markets — even if we may not see a technical recession.

We also believe we’re likely to see more significant financial sector and refinancing risks in the US over the next few years when more than US$3 trillion of debt comes due. We believe this is likely to have a large impact on the corporate sector, leaving credit assets vulnerable in the face of the potential drag on profit margins resulting from higher interest rates.

What does this mean for income investors?

  • It may be prudent to consider allocations to high-quality, short-duration credit and avoid riskier positions with high levels of default risk.
  • Defensive equities may be compelling against this backdrop

2. Consider being “focused yet diversified” in the search for return

This year has continued to see mixed macroeconomic data and a wide range of potential outcomes, with many surprises along the way. Perhaps the biggest surprise of all has been in global stock markets, with the strong recent performance of cyclical stocks and the sharp rally in US mega-cap technology stocks. While mega-cap technology is likely to benefit from the rollout of AI-enhanced products and services, the rally in cyclical stocks is more difficult to explain.

However, in our view, earnings growth estimates are unlikely to remain in double-digit territory against an economic environment of slowing growth. Current earnings growth estimates are also at odds with the very high valuation multiples that many stocks demand — even though a deteriorating macro environment may challenge their growth prospects.

Against this backdrop, we believe it’s important to take a diversified approach to security selection, particularly within equities. Instead of relying heavily on cyclicals versus defensives or growth versus value, we believe there are attractive opportunities for alpha generation across a wide range of different asset classes that may be captured by active managers. In our view, investors who place a greater emphasis on security selection may be better positioned for the period ahead.

For example, as a result of capital expenditure in AI we are positive on both select cyclical opportunities in the information technology sector, where valuations still look attractive, as well as the US homebuilding sector, where we see a strong supply/demand imbalance for single-family homes. On the other hand, we also see attractive opportunities within defensive stocks that have attractive fundamental attributes and a low correlation to global equity markets in order to provide diversification benefits.

What does this mean for income investors?

  • They may do well to avoid large portfolio factor biases.
  • High-conviction opportunities that have complementary risk profiles may be beneficial.
  • Focusing on risk metrics such as correlations during portfolio construction could be helpful.

3. Market fragilities may cause further dislocations or shocks

We believe periodic asset dislocations are likely to remain a key feature of the global landscape. Navigating through such potential shocks will be key for income-minded investors who prioritise capital stability. Turbulence in the US banking sector in early 2023 served as a stern reminder of how fragilities can rock markets.

In our view, effective risk management includes both seeking to avoid “risky” areas of the market and implementing dynamic portfolio hedging. Recently, we’ve seen a sharp fall in implied volatility in the markets; this shift has led to more affordable opportunities to hedge against sharp market risks that could offer significant protection in case of sudden shocks hitting both equity and bond markets.

We also believe such dislocations can offer interesting entry opportunities for allocators with ample liquidity who are able to rotate quickly in response to changing market environments. Here, we consider the turmoil that beset the UK fixed income market in September 2022. Some income investors used that episode to their advantage by initiating select positions in UK investment-grade corporate bonds with outsized yields and temporarily depressed values.

What does this mean for income investors?

  • It may be prudent to prioritise stability and risk mitigation, even if it means “giving up” a bit of yield or returns.
  • Maintaining adequate portfolio liquidity to be able to move swiftly to exploit market dislocations as they arise could be beneficial for income-seeking investors.

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