Active Thinking

At GAM Investments’ latest Active Thinking forum, David Dowsett discusses a difficult last quarter, the building value in the core fixed income market and the outlook for current dollar strength.

05 October 2022

David Dowsett, Global Head of Investments

The month of September was particularly grim for investors, with only silver futures delivering positive performance. The third quarter also saw negative performance across the board, with the exception of the Brazilian equity market.

Looking ahead in the short-term, we believe the next couple of weeks could be very challenging. We are seeing a very rapid contraction of global liquidity. Despite the policy specific reasons for the activity in the UK gilt market last week, this was an example of that contracting liquidity. Essentially, a policy change resulted in an outsized move in a financial market instrument.

This period presents challenges, but we may also see opportunities once we are through it – indeed, we believe we may see the low point for the year within the next two weeks. While it is difficult to say exactly when this low point will be, value is building, particularly in the fixed income market, and it is becoming progressively more difficult to be underweight core fixed income, in our view. Two-year yields in the US now sit at 4.25% and price in a significant amount. The penalty for being underweight in fixed income is significant with the yield on offer, regardless of whether or not yields go higher.

We are also focused on the rise in real yields from the negative rates that we have seen previously; however, the medium-term has already seen plenty of structural adjustment. 10-year negative real yields in the US of -1% on a forward-looking view have adjusted this year, with the current real yield on a 10-year bond at around 1.75%. We believe it is realistic to think that a level of 2-2.5% is all that is required to adjust to a period of normalised interest rates and higher inflation, rather than the emergency interest rate environment that we were in.

We believe the first place that investors will express risk is in high yield and credit. With the current yield compensation and significant breakeven attractiveness in the asset class, we think there is an opportunity for those who are looking to re-establish exposure after the difficult quarter and have a risk budget to spend.

Currencies have seen severe moves recently, which are largely attributable to dollar strength rather than currency weakness. Global liquidity is tightening while the US economy looks most resilient. This could potentially create some systemic vulnerabilities given much of the rest of the world owes money in dollars. The current 20-year period of dollar strength cannot continue forever, in our view – the US has a twin deficit problem that should not be ignored – so this potentially builds a valuation case for non-US assets in the medium-term. In the short-term, however, this could be one of the factors that could cause a systemic event.