Inflation. 7 hikes priced in….7 hikes communicated
As you know, we thought inflation was more permanent than transitory last year. The market moved quickly to take that on board. Over the space of about 3 months, the market moved its US interest rate expectations from 2 to 7 rises this year. The US Federal Reserve (Fed) duly delivered, with a 25bps hike last week whilst communicating the chances of further hikes at each of its remaining meetings this year.
US Federal Reserve Chairman, Powell, also said that reducing inflation “may take longer than we like” whilst also confirming that the Fed expected the US economy to grow above trend this year. We should have seen pressure on markets across the board, given the more hawkish tilt on rates. However, the Nasdaq ended up rallying 4% and the S&P 2%, with Treasuries tightening the morning after.
Perhaps the lack of a big 50bps rise in rates, that in in our view would have been warranted, has settled markets somewhat. There is still the real risk that the Fed is behind the curve. We are also going to see inflation that moves higher than reported numbers given the impact of the war on supply chains and commodity prices.
Inflation will define 2022
Inflation will probably define 2022. The likelihood is that we will continue to see upwards pressure on inflation exacerbated by the events in Ukraine. Raw material costs and food inputs (Ukraine and Russia produce approximately 30% of the world’s wheat) along with huge commodity price inflation will begin to squeeze both living standards and corporate margins. Companies won’t be able to pass on price increases at some point. Furthermore, higher wages will place further pressure on prices.
Can the Fed’s stance of putting the brakes on neutralise monetary policy without triggering a recession? Even with interest rates at 2%, we are still looking at significantly negative interest rates. However, so far, the Fed has not moved into a contractionary policy, which would require far more aggressive hikes, leading to a shrinking economy. That’s our concern.
On the flip side, as we have seen with the large swings in the oil price, if we do have some degree of resolution in Ukraine, and we see WTI oil prices drop back to $90 or lower, plus supply chain elevation, then we may see inflation begin to naturally decline. Also, we are already seeing some effects of higher inflation on consumer behaviour, which will also dampen demand. This is a big ask, but still within the realm of possibility. From our view, we will see the economy begin to slow and that will obviously impact asset prices. We believe that the Fed is likely to move on interest rates pre summer and then pause into the US mid-terms, so 2022 may well be the year of rate rises, and 2023/24 back to easing mode in the face of a slowing economy.
What does this mean for Fixed Income?
In our view, the US would seem to offer the best opportunities at present, given it is shielded to some extent from the cost pressures Europe is seeing from energy prices. Labour shortages and cost continue to be a big issue in the US and obviously interest rates are going up. Much of this bad news is already priced in. This means investment grade bonds and higher quality high yield are beginning to look interesting.
There are still headwinds in terms of inflation and a slowing economic environment, but with a longer-term view, these levels tend to be good entry points. One does need to differentiate between the US and Europe for now, given the differing economic backdrop. It remains to be seen how robust and enduring growth will be in the US, but we believe it seems to be a better environment for credit at this point in time.
Portfolio Positioning
Across global fixed income strategies, we have gradually reduced our Emerging Markets (EM) exposure over the last several months with the view that EM was not offering enough of a discount to Developed Markets given the elevated idiosyncratic risk.
Our duration hedges have moved from the 10 to the 5-year part of the curve in the US, given interest rate expectations and therefore, pressure on the shorter end of the curve. In Europe we have 10-year Bund hedges on. We have also hedged out some of the High Yield risk, although the High Yield market has remained determinedly resilient so far.
We continue to focus on making sure our holdings are robust enough for the inflationary and supply chain headwinds we are seeing.
Outlook
We could see some consolidation on any kind of ceasefire between Russia and Ukraine. However, the likelihood is that markets will continue to be volatile. At this point we are beginning to look for opportunities given how much bad news is being priced in. Caution continues to be the watchword as we wait for more inflation data.
The good news is that we are still at the beginning of the year, and there is still all to play for. Risks are elevated but so is volatility, and that tends to present opportunities for actively managed funds.
IMPORTANT INFORMATION
This marketing document contains information or may incorporate by reference data concerning certain collective investment schemes ("funds") which are only available for distribution in the countries where they have been registered. This document is for the exclusive use of the individual to whom it has been given and may not be either copied or transferred to third parties. In addition, this document is not intended for any person who is a citizen or resident of any jurisdiction where the publication, distribution or use of the information contained herein would be subject to any restrictions or limitations.
The contents of this document are provided for information purposes only and shall not be construed as an offer or a recommendation to subscribe for, retain or dispose of fund units, shares, investment products or strategies. Before investing in any fund or pursuing any strategy mentioned in this document, potential investors should consult the latest versions of the relevant legal documents such as, in relation to the funds, the Prospectus and, where applicable, the Key Investor Information Document (KIID) which describe in greater detail the specific risks. Moreover, potential investors are recommended to seek professional financial, legal and tax advice prior to making an investment decision.
The sources of the information contained in this document are deemed reliable. However, the accuracy or completeness of the information cannot be guaranteed, and some figures may only be estimates. There is no guarantee that objectives and targets will be met by the portfolio manager.
All investment involves risks. Past performance is not indicative or a guarantee of future returns. Fund values can fall as well as rise, and investors may lose the amount of their original investment. Returns may decrease or increase as a result of currency fluctuations.
This communication may only be circulated to Eligible Counterparties and Professional Investors and should not be circulated to Retail Investors for whom it is not suitable
This document is issued by the following entities: in the UK: Mirabaud Asset Management Limited which is authorised and regulated by the Financial Conduct Authority under firm reference number 122140.; in Switzerland: Mirabaud Asset Management (Suisse) SA, 29, boulevard Georges-Favon, 1204 Geneva, as Swiss representative. Swiss paying agent: Mirabaud & Cie SA, 29, boulevard Georges-Favon, 1204 Geneva. In France: Mirabaud Asset Management (France) SAS., 13, avenue Hoche, 75008 Paris. In Spain: Mirabaud Asset Management (España) S.G.I.I.C., S.A.U., Calle Fortuny, 6 - 2ª Planta, 28010 Madrid. The Prospectus, the Articles of Association, the Key Investor Information Document (KIID) as well as the annual and semi-annual reports (as the case may be), of the funds may be obtained free of charge from the above-mentioned entities.
