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Fixed income

Coordinated demand destruction

Today, we’ll be focused predominantly on inflation and the central banks’ reaction function.

First, let’s not forget that the COVID response resulted in huge debt burdens for most countries. This will be an important part of the discussion by central banks given the consequences for balance sheet financing of a too aggressive approach to fighting inflation. 

Interest rates are also a very blunt tool, and inflation numbers by their nature are backward looking. This is not to say that we do not have a very real problem with inflation and its very real effect on consumer disposable income and living standards, but everything must be put into context.

Staying with COVID for a moment, cases are again rising exponentially. However, it would seem that hospitalisations are not. Most populations in Europe and the US have moved to treat COVID as an endemic. The one exception to this is China, which appears antiquated in its response to fighting the virus, as seen with the lockdown of Shanghai.

Coordination

With most Developed and Emerging Market countries now in hiking mode (ex-Japan), we are looking at a coordinated global approach (not by design I hasten to add) in trying to take some of the inflationary pressures out of their economies. We have moved from a world with no inflation, to almost double digits. I suspect that this will be more temporary than the market is anticipating. We are already seeing changes in consumer behaviour as a result of the increase in both energy and food prices. This will naturally slow demand as we move through the next 12 months or so, and we are likely to see some alleviation of supply chain pressures as companies redirect their own supply chains, or we see a degree of normalisation as the world moves on from COVID.

Added to this slowing activity will be the reaction of China to COVID. The lockdown of Shanghai will weigh on domestic growth and therefore demand. Can we see stagflation? The risks have increased but at the moment it is likely that we will see front-end loaded rate hikes in the US, followed by a peaking of inflation in the second half of 2022 as the economy begins to slow.

This would be the ideal scenario, which therefore means it will probably not happen. However, in our view, some iteration of this appears realistic given the US economy is still robust, with unemployment still declining. The consumer will be key, and I do think we will begin to see a reduction in demand over the coming months, which will temper inflation.

Inverted curves – recession coming?

We saw the two-year part of the curve versus the ten-year part of the curve (2yr vs 10yr) in the US invert, which immediately saw the market narrative change to recession expectations. The market is still concerned that the US Federal Reserve (Fed) will hike rates too fast (given it is now late to the party) and will create a recession in the face of the large inflationary headwinds it faces. The Fed does not see the 2yr vs 10yr inversion as a cause of recession, merely interest rate expectations. There is some mileage in that argument, particularly given how quickly we have moved expectations of rate rises this year. Bloomberg has highlighted the 3m10yr curve – another recession indicator – which is moving in the opposite direction. What it does mean (if anything) is that the risks of recession are rising, especially with the Fed now being seen to be behind the curve. On the flip side, the US economy is still ok, and it is unlikely that the Fed will blindly precipitate a recession. I expect them to raise quickly into the summer and then pause as we enter the mid-term elections. Also do not forget, the market is doing some of the heavy lifting on tightening financial conditions already. Look at 30-year mortgage rates in the US.

Can we draw any conclusions from Emerging Markets?

If you remember, it was Emerging Markets that began to raise rates aggressively last year in order to bolster currencies and try to deal with inflationary pressures. We are now seeing some of the effects of that, and it looks like the tightening cycle may be coming to an end (Russia excluded of course). According to Bloomberg, Brazil has said it plans 100bps more in May, whilst Chile and Columbia have been more dovish than expected. Economies have slowed as inflation has led to demand destruction. The replacement of stimulus for tightening has also added to the headwinds Emerging Market economies are facing. Europe and the US is at the beginning of this journey, but perhaps we can draw some conclusions from what has happened elsewhere.

What’s happening in Europe?

Europe is lagging the US in terms of growth prospects, and it is now seemingly behind in fighting inflation. Europe has a much worse issue with energy given the reliance upon Russia. I will not go into the threat of Ruble payments or gas withdrawal, for example - you can read that elsewhere for those details. Recent numbers have not looked good. According to Bloomberg, producer prices are increasing over 40% and inflation is up to high single digits, which is unheard of. All these pressures are being felt in Italy, Germany and Spain. The European Central Bank (ECB) will have to revise its inflation forecast for 2022. Christine Lagarde, President of the European Central Bank, continues with the mantra of being data driven, but what else is needed? It is likely that the conditions for meeting the medium term 2% inflation target have been met, which means rates will go up. Will markets soon be pricing in 3 rate hikes this year?

A tricky start to the year

Rather counter intuitively I am not as concerned about inflation as I was last year. I do think the headline numbers look challenging, but I also think that we will see quite rapid changes in consumer behaviour that will result in some loss of demand. This will help take some of the heat out of the inflation data.

Given what is being priced into the markets, I am beginning to look at longer duration credit as an opportunity.  However, I’m still mindful of the headwinds that we face. The largest of these relates to the fact that risk assets are completely blind to what is going on. Is this complacency, “TINA” (there is no alternative) or too much cash? Who knows, but the bottom line is that equity markets are back to pre-war levels (Bloomberg sees the S&P almost back to the highs on 4 January this year), despite poor liquidity, pressure on profit margins going forward given higher costs and less ability by companies to pass those costs on, falling revenue as economic growth slows, and a war that is by no means over. These points are not exclusive but show that we still have a lot of risks to process.

The impact of oil

One positive glimmer is the oil price and its reaction to headlines in relation to the war between Russia and Ukraine. Much has been made of the link to the rapid rise in commodity prices (oil, wheat, steel etc) but what we have not yet really worked out is how much of this is the result of the war. It was interesting to see how quickly the price of oil fell at the mere suggestion that a ceasefire might be on the cards. I do not think that we can underestimate the effect on commodities should a ceasefire actually become a reality. We believe that oil could drop to below $100 per barrel, and some of that cost inflation will be removed. Perhaps wishful thinking but something to consider, nonetheless.

Furthermore, according to Bloomberg, another headwind for oil is China’s COVID lockdown measures, which affect 62 million people according to Bloomberg calculations. That is approximately 4.5% of the population and therefore 4.5% of oil demand. In real terms that is more than 600,000 barrels a day of consumption that traders probably weren’t expecting to lose. There is also the fact that Russian production could pivot to Asia, thereby mitigating the expected lost global supply that the price of oil is anticipating.

Portfolio activity

How are we dealing with the potential slowdown in consumer activity? We are still running with the re-opening trade given normalising economic activity, which seems counter intuitive. However, from my conversations with airlines and cruise companies, demand is still very strong. We are more concerned with those companies that cannot pass on price increases or are in sectors most sensitive to changing consumer behaviour, such as retail. Cyclically sensitive companies are also a focus as we look to slowing activity in the medium term.

It has been challenging to try to anticipate the direction of duration and credit risk since the beginning of the year. There are several conflicting influences on both that has resulted in large oscillations in Treasuries and Bunds – often daily – that have made hedging more complicated than usual. Not only have we moved to a very significant number of interest rate rises for 2022 in the US (over 8 at the last count) but we have also seen increasingly hawkish messaging from the Fed.

We are very active with our hedging overlay across our global fixed income strategies. We recently moved the Treasury bond hedges to the 5-year part of the curve in anticipation of interest rates driving a curve flatter. This was the correct decision and we have added value from that move. Since then, with so many rate hikes being priced in, I felt that there was not much left in the shorter end of the curve, so I removed half of the US Treasury 5-year hedges and began to hedge the 5-year part of the Bund curve, given the ECB seems to be somewhat behind the US in its reaction to the threat of inflation. I also added back some of the 10-year Treasury hedge in anticipation of some improvement in the Russia/Ukraine negotiations, but this is not a strong conviction, more as a tail risk hedge.

We have also gradually increased our credit hedge via ITRX indices short positions. We have been adding to better quality credit and duration where it makes sense, whilst maintaining our hedges. This is on the margin, and we are still waiting for better levels to add to longer duration credit.

Looking ahead

Markets always over-compensate, and this time is no exception. The number of interest rate rises that have been priced in may well not be what happens given the uncertain economic and geopolitical outlook. We remain cautiously constructive – this is the beginning of a new Fixed Income cycle, and we believe that we can benefit from the recalibration of risk and the fact that real returns are now available to investors who want some Fixed Income exposure. The path of travel will be bumpy but at the end of the day opportunities will present themselves and we are in a good position to benefit from the volatility we are seeing.

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