Fidelity International Outlook 2023

Outlook 2023 Navigating the polycrisis An investor’s guide to the year ahead for the global economy, multi asset, equities, fixed income, private markets, and real estate This is for investment professionals only and should not be relied upon by private investors Nord Stream photo by Danish Defence/Anadolu Agency. Other images by STR/AFP, Alfred Gescheidt, SERGEY BOBOK/AFP, Kevin Dietsch via Getty Images

Foreword The impact of the events of the past year will be felt long into the next one, particularly the tragic consequences of the Ukraine war. Chief among them from a financial perspective is the shift in monetary regime, from one supportive of global markets to one with a focus on taming inflation. This is challenging the outlook for assets and global economic growth and has led to both the ongoing volatility that has been a feature of 2022 and increasingly tight liquidity conditions. Central banks have outlined their concerns about supply side pressures that could embed inflation into economic systems and lead to rising wages and prices. As they tighten financial conditions in response, the risk of a hard landing is increased, and could play out as an economic contraction and labour market weakness. For equities this will be expressed in lower corporate earnings, while in debt markets we are watchful for rising default rates and downgrades. Other risks, including geopolitical uncertainty and a gradual decoupling of large economies from globalised supply and cooperation networks, may exacerbate the challenges facing asset markets in 2023. Meanwhile, consumer spending is at risk of a sharp decline as households battle a combination of higher energy and debt servicing costs. However, there are signs that some of the pressures of 2022 may ease into 2023, particularly in terms of supply chain disruption and transport. Prices for air, sea, and land freight are falling and the backlogs created by Covid lockdowns are easing, which may help to soften the blow on consumption. The gradual removal of quarantine restrictions globally has boosted investor confidence, with China now the only major economy where significant requirements are still in place. Further relaxation there would remove a distinct hurdle for both China and the global economy. With so many factors in play, and many of these pointing to increased downside risk, we maintain a cautious outlook in preparation for the next 12 months of uncertainty, whilst always being mindful that markets are forward-looking and sentiment will rise before the data shows the economy to be on an improving track. Anne Richards CEO, Fidelity International 2 Investment Outlook Fidelity International

Contents Overview 4 Macro 6 Multi asset 9 Equities 11 Fixed income 14 Private credit 17 Real estate 19 Investment Outlook Fidelity International 3

Overview Andrew McCaffery Global CIO, Asset Management Rates overshoot risks inflation bust Inflation has dogged markets this year and is likely to remain high, bringing an end to the era of easy money and increasing the risk that overtightening by central banks will trigger a sharp recession, an “inflation bust”. Markets want to believe that central banks will blink to be a wrecking ball for other economies, and change direction, negotiating the economy both in the developed world and for emerging towards a soft landing. But in our view, a hard countries that rely on hard currency debt. If the landing remains the most likely outcome in 2023. Fed continues to raise rates, an even stronger The previous norm of central bank “whatever it dollar could accelerate the onset of recession takes” intervention during the financial crisis and elsewhere. Conversely, a marked change in the pandemic is going or has gone. the dollar’s direction, potentially as its relative Until markets absorb this fully, we could see strength and confidence in monetary and fiscal sharp rallies on the back of expected action by policy making become an issue, could bring the Fed, only for them to reverse when it doesn’t broad relief, and increase overall liquidity across materialise in the way they expect. Rates should challenged economies. eventually plateau, but if inflation remains sticky Other parts of the world are on different above 2 per cent, they are unlikely to reduce trajectories. Japan has so far maintained looser quickly even if banks take other measures to policy settings; but any shift away from its current maintain liquidity and manage increasingly yield curve control could lead to unintended challenging debt piles. consequences for the yen and potentially add A key factor to watch is where the dollar goes another layer of risk to the already elevated from here. In 2022, the strong dollar has proved levels of volatility in FX markets. 4 Investment Outlook Fidelity International

China too has taken a different pathway in As the dispersion of returns increases, investors 2022, thanks to its zero-Covid policy and the will be able to seek out idiosyncratic elements in reining in of its property market. In the next 12 their portfolios rather than rely on whole market months, we expect policymakers to continue moves to generate returns. Opportunities should to focus on reviving the economy, investing in also begin to emerge among securities driven longer-term areas such as green technologies by longer-term themes such as decarbonisation and infrastructure. Any loosening of Covid and reindustrialisation, which could draw investor restrictions will cause consumption to pick up. attention sooner rather than later. The deglobalisation that has arisen from the pandemic and tensions with the US will take time to work its way through but is a theme that will grow. In this Investment Outlook, our asset class experts consider how to navigate this unusual crisis- driven cycle in 2023. Emerging markets and Asian countries, with a weaker growth correlation with the US and Europe, present one way to increase diversification, while cash and quality investment grade securities offer defensive characteristics. Traders work on the floor of the New York Stock Exchange. Credit: Spencer Platt / Staff, Getty Images. 5 Investment Outlook Fidelity International

Macro Salman Ahmed Global Head of Macro and Strategic Asset Allocation What happens next depends on the Fed As we move into 2023, the global economy continues to face a confluence of challenges. From persistently high inflation and aggressive global policy tightening (led by the Federal Reserve) to the continued fallout of the Russia-Ukraine war and the energy crisis, weak consumer confidence and political disruptions, our base case remains a hard landing. Through the last quarter of 2022, our proprietary activity trackers have indicated a continuing slowdown, with a recession likely in the US and near certain in Europe and the UK. In the US, the Fed appears set on raising rates late for the US economy. Real rates have been significantly beyond neutral levels to bring inflation positive for some time and in some parts of the under control. We do not expect a pivot until yield curve pushing towards pre-Global Financial there is a meaningful deterioration in hard data, Crisis (GFC) levels. We have repeatedly argued especially inflation and the labour market. The that the financial system cannot take positive real US housing market is already showing signs of rates for any material length of time (due to high stress, as higher mortgage rates and reduced levels of debt) before financial stability becomes an affordability stifle transactions. However, inflation issue. Given liquidity and assets are already under and the labour market are still strong, compelling considerable pressure, the system could start to the Fed to keep going, given their focus on current crack. There is a risk that if the Fed stays true to its spot data against the backdrop of underestimating current word and doesn’t stop until inflation is back inflationary pressures last year. near 2 per cent, a “standard” recession could turn At this juncture, one important concern is that the Fed into something worse. is too focused on backward looking data, especially in relation to the labour market. By the time that shows signs of weakness, it may already be too 6 Investment Outlook Fidelity International

Chart 1: Financial conditions tighten globally This could limit central banks’ ability to support 105 growth with monetary stimulus, marking a regime change from the disinflationary post-GFC era 104 when real interest rates (interest rates adjusted 103 for inflation) were consistently driven further into 102 negative territory to support growth. As noted 101 above, the market reaction to the UK government’s 100 recent fiscal expansion plans demonstrates the Financial Conditions Index99 difficulties that policymakers around the world Jan 2022 May 2022 Sep 2022 could face when seeking to support growth while US EA UK simultaneously controlling inflation. Notes: FCIs rebased to 100 at 31 December 2021. Higher values indicate tighter financial conditions, while lower values indicate looser financial conditions. Source: Fidelity International, Bloomberg, November 2022. We will be watching for signs that Alongside central banks, governments will have an the Fed and other key central banks important role to play in driving macroeconomic are wise to this possibility and other prospects for 2023. As we’ve seen in 2022 from the risks, potentially easing off tightening market gyrations caused by UK fiscal policy and in some cases until the impact of political uncertainty, combinations of monetary previous tightening is clearer. tightening and mis-judged fiscal decisions have the potential to turn into financial stability risks. Indeed, the UK is not the only economy confronting fiscal Europe has its own set of problems to deal with. and monetary policy challenges simultaneously, so Its 2023 will be decided by the direction of energy it may prove a canary in the coal mine. prices, the nature of fiscal support provided to We will be watching for signs that the Fed and consumers, and the weather. A warmer winter will other key central banks are wise to this possibility reduce the chance of gas rationing or blackouts and other risks, potentially easing off tightening due to lack of supply (early indications are that in some cases until the impact of previous this might be the case based on Europe’s Weather tightening is clearer. In any case, inflation is likely Centre (ECMWF) and UK Met Office forecasts, to moderate, but we expect it will do so gradually. which is good news). Alongside the continued Indeed, structural trends such as decarbonisation, tragic human cost of the Russia-Ukraine war, energy deglobalisation, and the process of dealing security will remain top of the agenda for Europe with high debt levels are likely to keep up the and the UK, which could be a significant driver of inflationary pressure over the coming years. capital in the future. 7 Investment Outlook Fidelity International

Another significant determinant of 2023’s economic feed-through in areas ranging from digitisation, picture will be China. There are tentative signs that national security and the focus on self-reliance to strict anti-Covid measures will be relaxed (though the opening up of capital markets, while keeping a slower than expected), which would be positive for close eye on the tense US-China relationship. economic growth, and we expect monetary and What does all this mean for investors? While fiscal policy to stay loose (and be loosened further), the macroeconomic outlook for 2023 makes for putting a floor under economic developments disconcerting reading, it is important to remember which have been under severe pressure. that markets rarely follow economics in straight Uncertainty about the future of renminbi price lines and the appearance of ‘value’ across asset trends persists; we believe the PBoC is willing to classes (especially in fixed income and some parts accept some depreciation to support export growth of equity markets) will be an important trend to especially given relatively low inflation. In the assess alongside macro developments. wake of the 20th Communist Party Congress, we will be watching closely to see the potential policy Federal Reserve Board Chairman Jerome Powell. Credit: Brendan Smialoswki / Contributor, Getty Images. 8 Investment Outlook Fidelity International

Multi asset Henk-Jan Rikkerink Global Head of Solutions and Multi Asset Defensive for now until volatility subsides Global asset markets face no shortage of headwinds as we look ahead to 2023. As the Federal Reserve attempts to get a grip of soaring inflation in the US, the dollar’s rapid appreciation has sucked capital away from other regions. Europe and the UK are in the middle of an energy crisis, with no clear endpoint for the devastating Russia-Ukraine war. Inflation remains high across most global regions, consumer confidence is at rock bottom, and China’s economy is stuck in first gear. This multitude of challenges paints a complicated investment backdrop heading into next year, and we expect volatility to remain high for some time. We believe defensive positioning will remain not reflected in earnings forecasts or valuations, important for investors going into 2023. Cash and implying there could be further downside to come. uncorrelated assets will form a key component of multi We expect volatility to remain high, and sentiment asset portfolios until volatility subsides. Government is low enough that sharp risk-on bounces will be bonds are also likely to have a role to play, especially likely, if short-lived. Earnings estimates for 2022 have now that yields are much more attractive. If 2023 gradually declined as the year has progressed, brings a hard landing, as we believe it will, central but estimates for 2023 have barely budged, an banks should ease off hiking rates as growth slows. anomaly given the challenging outlook for the The structural tailwinds that drove the bond rally over coming year. Valuations have fallen somewhat; the last 40 years may have diminished somewhat, pockets of real value are emerging. However, many but government bonds are still the go-to asset for markets are a long way from what we might call portfolio diversification in a recession. ‘cheap’ compared to history. Deteriorating environment not yet Potential catalysts for sentiment to reflected in equities pick up The time will come to allocate back into equities As we move into 2023, we are focused on too. But for now, the deteriorating environment is finding pockets of growth in a low growth world. 9 Investment Outlook Fidelity International

While the overall investment outlook is gloomy, Deglobalisation there are several themes that could provide the We expect the structural theme of deglobalisation catalyst for sentiment to improve. and re-shoring to continue in 2023. China is going First, signs that hard US data is moderating could through a transition phase, and we believe the be a harbinger of the much-feted Fed pivot. gradual bifurcation of China and the West will Although we do not expect it soon, when it does continue. While this may be a drag on China, arrive, it should boost risky assets such as equities the reconfiguring of supply chains will provide and credit, as well as government bonds. opportunities for other countries too, especially Chart 2: Job market and wages have peaked Mexico and Canada, but also some Latin American but remain strong economies and Thailand and Vietnam. 7.5 2.4 Less correlated exposures will be an 5.0 1.6 important part of the investment arsenal 2.5 0.8 Of course, the first rule of multi asset investment is to understand the difference between asset 0.0 0 behaviour over the long and the short term. 2005 2010 2015 2020 Over a longer time horizon, we see no reason Atlanta Fed wage growth tracker smoothed for undue pessimism. Economies will survive Atlanta Fed pre-Covid average Ratio of job vacancies to job seekers (RHS) this particular bout of challenges and doubtless Average pre-Covid ratio (RHS) emerge stronger when they do. As long-term Source: Refinitiv, Fidelity International, October 2021. investors, it is important not to lose sight of the big picture, but to be alert to opportunities Second, any relief for European consumers, along the way, with the aim of both capturing either by an unexpected end to the war or a short-term upside and mitigating downside. comprehensive fiscal support package would In 2023 and beyond, we believe multi asset improve the region’s outlook. investors must make use of as broad a toolkit as Third, any indication that Chinese authorities are possible. From liquid absolute return strategies prepared to relax strict Covid rules or refocus on (aiming for positive, uncorrelated returns) to growth and away from reform would be taken listed alternatives (including infrastructure and very positively by markets. renewables) to private assets (including private Lastly, we will be watching guidance from the Bank equity, private credit and real estate), less- of Japan closely for any indication they are ready correlated exposures will be an important part to step away from yield curve control. This would of the investment arsenal. Indeed, the coming stem the yen’s devaluation and could potentially years and their challenges call for wider sources push global government bond yields higher. of diversification and risk, where investors will be forced to look beyond traditional assets to deliver outcomes over the long term. 10 Investment Outlook Fidelity International

Equities Marty Dropkin Ilga Haubelt Head of Equities, Asia Pacific Head of Equities, Europe Market uncertainty to remain high amid tighter policy We expect a high degree of volatility and uncertainty for global equities in 2023, as stubbornly high inflation and interest rate rises lead to a rough landing for large parts of the global economy. However, earnings expectations are diverging across different economies, allowing investors to capitalise on select opportunities. Markets continue to expect central banks (led by After the sharp sell-off spurred by the worsening the US Federal Reserve) to stop hiking at the first outlook and government missteps, there is a sign of inflation cooling, but there is a growing case for the UK equity market becoming an risk that by then it may be too late. The squeeze attractive hunting ground in 2023. While the UK on the consumer is already taking place and market has done better than most this year, some parts of the global economy are headed partly due to sector composition (with most large for recession or are already there. cap earnings derived from outside the UK), it remains relatively cheaply valued with a forward Regionally, Europe looks the most exposed. PE that is around 25 per cent below long-term Much depends on whether businesses and averages and close to 50 per cent cheaper than consumers can make their way through the the US. The large cap FTSE 100 index remains winter without blackouts that weaken demand primarily a play on the global economy and a and on how the Ukraine conflict develops from beneficiary of sterling weakness, while small here. Tail risks for stock markets remain and and mid-cap names tend to be more exposed a recession seems baked in, as the European to the domestic economy. The latter are unloved Central Bank ploughs ahead with rate rises at and could be beneficiaries of any positive a time when households are already suffering surprise on the economic front. from the surge in the cost of living. 11 Investment Outlook Fidelity International

The US presents a different picture. While Chart 3: 12m Forward Price to Earnings (MSCI AC there are some signs of increasing pressure World) - Expect further downward revisions in 2023 on consumers, real data has yet to turn 25x downwards, and markets are some way off pricing in the sort of corporate earnings 20x downgrades that would reflect a full-blown recession. That leaves us with the risk of a 15x more dramatic drop in the S&P 500 next year 10x if growth slows suddenly. Nevertheless, small/ mid-cap stocks appear cheap relative to large 5x caps, which should present some opportunities. 2000 2005 2010 2015 2020 Meanwhile, growth stocks still look relatively 12m Forward PE Average +1 s/d +2 s/d expensive versus value stocks, with the -1 s/d -2 s/d valuation gap at historic highs. Source: Fidelity International, IBES, 15 October 2021. Note: Consensus estimates based on IBES MSCI Dollar strength World forecasts. Another potential risk for investors is further Investors should also monitor the trajectory of US dollar appreciation, which would continue China. Not only is it a big market in its own right to erode corporate earnings. Emerging but it was also among the first in and first out of markets have historically been especially lockdowns, and the first major market to show signs sensitive to changes in the greenback’s value of earnings fatigue. Its performance in the coming and US companies are not immune to these months may indicate how things will play out in headwinds as their offshore revenues begin developed markets. to shrink. The S&P 500’s foreign exposure is China is investible but investors around 30 per cent. For global equities, multiples will continue to need to be selective decline as discount rates rise. Corporate profits In China, monetary conditions are more and earnings will need to adjust further to accommodative with relatively low inflationary reflect the uncertain economic picture, which is expectations. The big question for the first months likely to persist near term. Valuations are likely of the year is whether the economy can start to come down further as companies publish to perform. Unlike Europe there is no energy annual earnings numbers and expectations in crisis, and our base case is for a moderate the first quarter. and gradual recovery of growth as the year 12 Investment Outlook Fidelity International

progresses. Domestic earnings will improve, Regionally, we are more positive versus consensus as should margins, against the backdrop of in Asia Pacific excluding Japan, with the Asean renewed levels of investment in infrastructure. and Indian economies standing out, building on a We are positive on consumer staples, financials, robust recovery thus far in 2022. Within the region, and healthcare, but in general much has been we are long-term positive on both India and discounted across the market. Indonesia, amid robust multiyear growth supported by favourable demographics, including a growing Caution required middle class and rising disposable incomes. On its own, Indonesia is a net energy exporter and is one If central banks remain excessively hawkish and of a few countries to benefit from increased energy over tighten monetary conditions through a mix prices, which should persist into 2023. of interest rate hikes and quantitative tightening, there is a risk of an inflationary bust this year, with Chart 4: Consensus earnings forecasts (FY23) economies struggling to mitigate the damage. This could hurt both the real economy and asset prices. Asia Pacific ex Japan We remain cautious of current conditions US and believe now is the time to be invested in high quality stocks that are best placed to Global weather market volatility, while also looking for EM opportunities to gain exposure to long-term secular growth sectors like clean energy and electric Europe vehicles. Defensive areas such as financials Japan and utilities could outperform as the economic 0% 2% 4% 6% 8% 10% slowdown takes hold. For utilities, we favour 2023 Est names (ex-US) with valuations that provide a good margin of error and where better cash generation/ Source: IBES earnings estimates, Fidelity International, 30 September 2022. certainty of returns will be rewarded, despite elevated power prices that are likely to come off - a headwind to earnings growth. 13 Investment Outlook Fidelity International

Fixed income Steve Ellis Global CIO, Fixed Income A new era for interest rates Bond yields are finally starting to look attractive again but are they priced for the scale of the downturn ahead? Fixed income markets head into 2023 hopeful of wrecking ball for a growing number of markets. a long-awaited shift to a new reality, yet the end At some stage, the Fed and other central banks of more than a decade of monetary largesse may be forced to balance their inflation-fighting has brought with it substantial risks. mandates with the need for financial stability. Central banks continue to tighten financial Chart 5: Corporate bond yields begin to look conditions, increasing the risk of an inflation bust more attractive versus dividends across a glut of economies. Even if policymakers Corporate IG yields minus dividend yields since 2002 are forced to back down by markets and the 8% scale of the prospective slowdown, we believe interest rates will settle far higher than they have 6% been at any point over the past decade. 4% This should be good for bonds, which have 2% struggled through a decade of zero yields, but 0% there are the first signs of cracks in financial -2% systems in response. UK authorities’ struggle -4% with the fallout of a budget full of unfunded tax 2005 2010 2015 2020 giveaways may well prove a model for others. US Europe The Federal Reserve in particular is pressing on Source: Refinitiv, Fidelity International, October 2021. with tightening that has turned the dollar into a 14 Investment Outlook Fidelity International

Too much too late Looking at duration It is clear that developed world central banks On the surface, the high risk of a hard landing began this round of tightening too late and that seems to make US and core Europe duration the outcomes are likely to be painful. Were the US relatively attractive. We expect policymakers will to head into recession next year, credit defaults finally be forced into a long-speculated pivot would rise significantly. So far, the market is yet towards easier policy. The difficulty over the past to reflect these risks, notably in high yield credit. year has been predicting when that will occur. At We calculate market implied default rates for the time of writing, the prospect of the Fed pivoting the high yield segment at just 2.7 per cent in the has been pushed out to at least March 2023. US currently - roughly what might be expected Inflation will likely prove the key to this. Consumer in a very shallow recession. By contrast, realised price growth in the US and Europe has remained defaults peaked at around 14 per cent during the stubbornly high, but the first falls may allow global financial crisis. Prudent credit selection central banks to shift. In turn that may finally halt within high yield is therefore essential. the dollar’s gains and allow emerging markets Chart 6: Default rates not priced for recession including China to start to grow faster. For Europe, the shock to energy prices and 18% associated risks have made the economic pain 16% more evident. Markets continue to project rate 14% 12% hikes lasting well into 2023; we reckon the ECB 10% will eventually deviate from this path and avert a 8% deeper recession. In the meantime, investors will 6% need to be highly selective. Credit spreads, both for 4% corporates and for the more stretched government 2% 0% borrowers, have widened significantly, but there 2000 2005 2010 2015 2020 may be more to come if soaring energy costs drive 5y implied default rate Germany into a deep recession. 1y implied default rate Elsewhere, emerging markets and Chinese property Source: Refinitiv, Fidelity International, October 2021. investments have been among the hardest hit by the dollar’s strength. That points to the potential for The interest burden is also likely to be crucial. If a big rally when the greenback finally turns, but it is high yield is to mean yields of 8-10 per cent in again perilously difficult picking the right moment. the months and possibly years ahead, then this With that cocktail of risks in mind, as we navigate will alter the outlook for both existing and future various stages of the hiking cycle, it is inevitable borrowers. Adjustments will be required across that some investors will look to shift portfolio asset the curve. 15 Investment Outlook Fidelity International

allocations towards higher quality assets. We can see that flight to quality already in recent demand for cash strategies. Not priced for a demand shock The biggest risk for us as investors is that policymakers may have already pushed the system too far. Monetary aggregates are falling at or to levels not seen since the Great Depression and yet central banks are pushing ahead with more tightening. As base effects kick in, we may discover that the inflation of the past 18 months is less sticky than we believed, and that we have negatively shocked domestic demand far more than was necessary. We are not priced for that yet and it could swiftly change market dynamics. Yields to hold higher for longer. Credit: Josep Lago / Contributor, Getty Images. 16 Investment Outlook Fidelity International

Private credit Michael Curtis Head of Private Credit Strategies Private credit may prove a defensive option The private credit markets could prove a defensive option as economies brace for recession in 2023, due to their structural features and the relative strength of the asset class. Private credit has features that can help investors Certain private credit products have always avoid the most dramatic levels of volatility in been resilient, with historicaly low default rates other asset classes, not least because as floating for collateralised loan obligations (CLOs) even rate structures they are able to provide increasing in times of stress (no CLOs have defaulted since income generation in a rising rate environment. the GFC, and even before then the few defaults Direct lending facilities, for example, can be long that did occur were mostly seen in BB-rated dated and tightly covenanted in lenders’ favour, tranches). Meanwhile, current spread levels in while senior secured loans enjoy the relative the senior secured loan market suggest that protection offered by their positioning at the very a fair amount of bad news has already been top of the capital structure. priced in. Current valuations imply a one year forward default rate of 19.1 per cent, around This inherently conservative asset class has also twice the greatest ever default rate of 10.5 per positioned itself defensively heading into the cent experienced during the GFC. For context, volatility. While default rates across the sector Fitch has predicted a 3 per cent default rate in are likely to increase over the coming year, these its base case for the upcoming volatility and should be limited compared to public assets, and 5 per cent in a more severe default scenario. any pricing weakness is likely to be less severe than it was during the Global Financial Crisis (GFC). 17 Investment Outlook Fidelity International

Chart 7: Implied 5y default rates appear into the GFC. That said, we believe the rating pessimistic versus worst historical levels agencies may not continue the lenient approach to 60% downgrades adopted over the pandemic. 50% More defences, but not immune 40% While we expect private markets to perform 30% relatively well into 2023 there will be opportunities 20% for investors to find assets at considerable 10% discounts, though careful due diligence will be 0% required to avoid value traps. The borrowers EUR EUR EUR USD USD USD that access these markets operate in the real Loans HY IG Loans HY IG economy, facing sluggish consumer demand, Implied 5y CDR rising rates, and market volatility. And although Worst historic 5y CDR issuers are not under intense pressure to Source: Credit Suisse Western European Leveraged Loan Index - EUR Only DM to Maturity; CS US refinance existing deals – the maturity wall Leveraged Loan Index DM to Maturity; High Yield and IG ICE BAML OAS; Data as of 19-Oct-2022. Recovery Rates assumed at 60% for Leveraged Loans, 30% for High Yield and 40% for IG based on of senior secured facilities that needs to be historical recovery rates and seniority. HY and IG historical default rates based on S&P 2021 Annual Global Corporate Default And Rating Transition Study (1982 to 2021). Leveraged Loan historical replaced before 2024 is only €18 billion for default rates from Morningstar US & European LL Indexes (2000 to 2022). EUR Leveraged Loans BDRs example - there will be some names that are down to 41% with 30% Recovery Rates and 31% with 0% Recovery Rates. forced into amend-and-extend deals, or that may A market made of sterner stuff even default. Although the recessionary backdrop will have Indeed, the European senior secured loan market an impact, we expect that many investors will is a fundamentally different beast now than it benefit from a relatively calmer environment in was going into the GFC. Back in January 2007, no the private credit markets compared to public deals were cov-lite, while some 97 per cent of the ones. Given the volatility and balance of control facilities in the market now have no covenants. shifting to lenders, we believe the next 12-24 This naturally reduces the risk of defaults going months could create opportunities in the private into 2023 as companies won’t break covenants credit space. that don’t exist, allowing cyclical companies more room to navigate to the other side of the turmoil. Similarly, interest coverage levels have strengthened over the last 15 years and now stand at around 3.9x compared to 2.7x in 2008, making the debt more affordable going into a potential recession. The proportion of CCC-rated facilities in the Western European Leveraged Loan Index has fallen to 4 per cent from 20 per cent heading 18 Investment Outlook Fidelity International

Real estate Neil Cable Head of European Real Estate Investments Challenges ahead but with potential opportunities Against a volatile economic backdrop, the real estate market’s focus is shifting towards the ongoing cashflow available over the next 12 months. As the tightening cycle slows and rates stabilise, however, opportunities should begin to emerge for investors prepared to take them. The coming year is likely to be a challenging one for Chart 8: European real estate set to reprice after real estate but should also create opportunities to spreads narrow more quickly than expected lock in higher yields and generate long-term value. 8 Signs of recovery in the wake of higher lending 6 rates could seem elusive in the first half of 2023. 4 Private markets are not as liquid as their public 2 counterparts and, as their pricing trends can lag 0 other asset classes, they may continue to decline -2 -4 over the first two quarters of the coming year. LogisticsOfficeDIYRetail WarehouseResidentialLogisticsOfficeRetail WarehouseLogisticsOfficeRetail WarehouseResidentialLogistics - LondonLogistics - RegionLogistics - West EndOffice - RegionRetail Warehouse But that will be precisely the period in which purchasers have the greatest negotiating power. Yields will rise further to reflect tighter financial conditions, but we don’t expect a cycle like that of the 1990s, nor that prices will sink to the lows of Germany France Netherlands UK the Global Financial Crisis. There are still plenty Spread over Eurozone Investment Grade bond yields 2021 of buyers in real estate and, given private market Spread over Eurozone Investment Grade bond yields 2022 investments have become a key part of many well-diversified portfolios, there is unlikely to be a Source: Fidelity International, CBRE, September 2021 and September 2022; Bloomberg, as at 30/09/2021 and 26/09/2022. wholesale withdrawal of capital from the space. 19 Investment Outlook Fidelity International

Instead, we expect the upcoming cycle to be Some buildings will become stranded as landlords relatively short. If interest rate levels begin to can no longer lease them unless they meet stabilise, we believe that most valuations will minimum standards. This will increase not only the readjust by the middle of next year. As the market ‘brown discount’ for non-compliant buildings but moves closer to the bottom, there will be some also the scope for the most sustainable buildings interesting opportunities for investors with long- on the market to attract outsized ‘green premia’ term capital to deploy. in the near term, especially as buildings with the strongest credentials are in short supply. The biggest differential may An eye on cashflow arise between buildings that are Finally, 2023 will be the year that the pricing sustainable and those that are not. landscape in the real estate market goes back to basics. After almost a decade of chasing ever-compressing yields due to the increased A return to rational pricing allocation of capital to the sector, we’re now entering a period where the focus will be on Indeed, we should see a fundamental cashflow - maintaining income where you can strengthening of terms in 2023. After a long and growing it where opportunities to pick period of low interest rates, during which a up higher-yielding assets arise. The focus on lot of real estate seemingly offered the same delivering alpha will remain but this will be much standardised yield almost regardless of quality, more a function of the quality of the building, and we’re now moving into a period of more rational the ability of the manager to actively manage it, pricing. This creates the potential for more than it will be of past drivers like historically low differentiated returns between sectors, property rates or prime locations. types, and locations that active real estate investors can take advantage of. Sustainability premia set to increase The biggest differential may arise between buildings that are sustainable and those that are not. Not only has the energy efficiency of a building become more important as energy costs have risen, but evolving regulation is continuously ratcheting up sustainability standards. With an alphabet soup of requirements from EPC ratings to Sustainable Financial Disclosure Regulation coming thick and fast across Europe especially, the next few years will bring huge opportunities and risks for those who can get ahead of the changes and those that get left behind. 20 Investment Outlook Fidelity International

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