So, I’m taking the plunge this week as both Sterling and Gilts are collapsing and we have a new right-wing leader in Italy. If that wasn’t enough, both Nordstream pipelines have apparently been sabotaged, so we are back to discussing the energy crisis in Europe, while upcoming referendums in Russian-controlled Ukrainian territory further ramp up geopolitical tensions.
Essentially, it’s a typical week in 2022.
Is this the final capitulation? Maybe, or at least we are close to it.
Markets have been extremely complacent (believe it or not) with how the interest rate/inflation/economic situation has been unfolding. We were talking about a pivot by the US Federal Reserve only a few weeks ago – that idea has firmly been put to bed by Chairman Powell in his comments after the 75bps rate hike last week. Volatility in Treasuries has been huge – up 80bps month to date, according to Bloomberg research, which is the largest monthly jump in approximately 20 years. In just one day, the 10-year hit the all-important 4% hurdle before dropping back to 3.79%. As we have consistently said, until this volatility subsides, we will not see investor confidence return.
So, what do we think?
We are still of the view that a soft recession is on the cards, that US inflation will begin to ease soon and economic data will weaken, with rates peaking at the end of this year/early next with a recession to follow shortly. This view has not changed, but clearly the risk of over-tightening and a harder recession has increased.
Inflation, by its very nature, is backwards-looking and monetary policy is a blunt tool. So far, employment has held up, but we are yet to see the impact of even the first hike. As such, our strategy of ‘up in quality’ makes sense. Our longer-duration strategy is dependent upon inflation beginning to fall away, but we continue to partially hedge this risk for now.
Inflation
We are confident inflation will begin to fall, but more slowly than perhaps we were expecting a few months ago. This indicates US rates will remain higher for longer. In Europe, we think a recession will come sooner, but the European Central Bank (ECB) is committed to fighting inflation, which means higher rates. Energy uncertainty also remains an issue, but perhaps less pressing than it was a few months ago.
If we think about inflation and the fact that it is backwards-looking, whilst the US consumer is still spending on services, we are seeing some signs that inflation may have peaked. Container/freight rates are down as demand has begun to fall. Commodity prices are also down – we were speculating oil prices at around $200 a barrel only six months ago. US home prices are falling and wages are not going up as much as feared, but we need to see what the next few data prints look like.
Gold
I have never been that keen on gold, but even with a background of rampant inflation, it has disappointed. This is because the opportunity cost of holding it is now significant when you consider where 1-year Treasuries are trading.
US Dollar
The dollar remains exceptionally strong, but has it peaked? When this will end, one cannot say, but it is likely that we will need to see interest rates top-out and some sign that the inflation picture is stabilising. This is bad news for emerging markets and other countries that are now dealing with imported inflation from US dollar strength.
UK
What a mess. The Bank of England (BoE) has had to step in to support LDI pension funds, where the leverage to Gilt positions has started to hurt. Sterling is in crisis and we are yet to see the effects on consumer behaviour, inflation and import prices. Banks are pulling mortgage deals in the face of interest rate uncertainty, so it is likely that there is more pain to come for the UK.
Employment surely has to be the next shoe to drop. At some point, Sterling will be a buy, especially if we see either a walk back by the Treasury or intervention by the BoE, but we could see further short-term pressure.
Positioning
Despite all this turmoil, I think there are some exceptional potential investment opportunities in fixed income at the moment. It is often when one is staring into the abyss and panic is unfolding that the savvy investor can make their most lucrative decisions. I believe we are close to that moment.
In my view, short-dated fixed income is looking attractive for the more risk-averse investor. 2-year Bunds are yielding over 2% and US Treasuries over 4%. Our Global Short Duration strategy has a yield of 5.65% with a duration of just over 1 year – I think that speaks for itself. The hedging costs of 200bps are also likely to come in over time, given the ECB has affirmed its commitment to fighting inflation. It is a bit behind the US in terms of its interest rate activity, but it will be raising rates aggressively.
The other area of fixed income where I’m seeing notable potential is long duration. We started a bit early here (but hedged out the duration risk as you know), but as we begin to see inflation slow (see above) and rates peak, the convexity here could be significant. Looking at some of the leading US tech giants, the longer-dated parts of these businesses’ capital structures are trading in the 60s (bond points) with yields of around 5.5%, give or take.
How is that influencing our positioning? We continue to hedge both credit and duration risk, but are very close to levels where we will begin to reduce our duration hedges. Credit still has a bit of selling off to do given recession and weaker corporate results are not fully priced in. We are waiting for that moment before we fully commit to buying credit risk again. Overall, we have been more active in our hedging than in the cash market. Our strategies continue to mitigate market weakness with active hedging.
Outlook
I think we are close to peak pessimism. We have to be realistic though and remain cautious until we begin to see a trend of lower inflation and lower economic activity. The short end of the curve is at its peak (or close to), given the rate rises being priced in. Unfortunately, data dependency means more uncertainty and more volatility for now.
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