It is now 12 years since we first started running our Multi-Sector Bond strategies and once again we have encountered a period of substantial market volatility, as the world faces the onset of tightening financial conditions coupled with the tragedy and far-reaching economic impact of a war in Europe. We felt therefore that we should share with you our thoughts on these issues, as well as some market colour on what we are seeing day-to-day in our fixed income markets. This will be the seventh time I have written such a letter – the last was in March 2020. One of our key objectives in writing has always been to encourage patience, which as history indicates can be a profitable tactic through such periods of volatility and we believe will be so again here.
By way of background, as 2021 drew to a close we saw a very unusual relationship between central bank policy, global economic performance and risk asset valuations. In our view central bank policy was still aimed at nurturing a nascent early-cycle economic recovery, global economies themselves were probably best described as mid-cycle, and risk asset valuations were at least mid-cycle or in some cases late-cycle. We were convinced these factors had to converge in 2022, and that while this happened we would experience some market volatility as investors across the globe digested the tightening of financial conditions they were about to face. Our strategy at this point in time was to carry excess liquidity to enable us to take advantage of what we saw as an upcoming intra-cycle dip, and to keep our credit exposures relatively short while valuations looked stretched. Coming into the year, we further shortened our interest rate duration via an interest rate swap to help protect our portfolios from the rising government bond yields that we expected in Q1.
Government bond yields did indeed surge in December and into January and February, as first the Fed pivoted away from its ‘transitory’ view on inflation and then the Bank of England put through its first interest rate hike. Markets began to price in more and more rate hikes as it became clear the US was approaching full employment and inflation became an ever greater concern across the globe. By the end of February markets were pricing in six rate hikes from the Fed in 2022, an incredible shift from what they were projecting just a few months earlier. Credit spreads had moved markedly wider as a consequence of this uncertainty. We felt this nervousness would persist until the next round of central bank meetings in March, where we expected to get more clarity on the pace and magnitude of rate hikes that the major economies were facing, as well as some more insight into how central bank balance sheets might be run down in 2022. We thought this could be the trigger that settled markets by soothing the volatility in government bonds. After all markets can perform well while financial conditions are tightening, it’s normally just the uncertainty around the timing that spooks investors.
So the intra-cycle dip that we had expected was indeed being created in the first two months of the year, at which point we would have looked to deploy some of the liquidity we were carrying to pick up bonds at more attractive yields. However, then came Russia’s invasion of Ukraine, an unprecedented raft of economic and financial sanctions and a rough sell-off as investors digested the news. As a consequence, we have held back on buying the dip that emerged in the first two months of the year as these highly unpredictable events are developing, though we did execute a few trades in February to try to improve our portfolios’ yield.
Since Russia’s invasion markets have reacted in the way that we would expect, sending credit spreads wider, equities sharply lower, and fuelling a rampant commodity price rally. We will avoid going into detail on all the sanctions imposed on Russia, but we believe it is clear that their net effect in almost all scenarios from here will be higher and broader inflation than previously expected, at a time when inflation was already at multi-decade highs. This poses a real conundrum for central bankers, as in nearly all scenarios growth will be slowing further while inflation spikes higher. We think the short term rate hikes for the UK and US are baked in, but whether the five or six 2022 hikes that markets were expecting back in February actually go through will depend on the various possible outcomes from the war and its related trade issues.
Before looking at today’s fixed income markets, we think it is first worth looking at the various scenarios for how we think the war in Ukraine could develop.
Scenario 1 is the most optimistic, and would see a diplomatic solution and ceasefire enacted in relatively short order. Some of the sanctions would be withdrawn and the main focus of the market would return to the tightening of financial conditions. In this scenario we would anticipate risk markets bouncing hard, commodity prices would begin to normalise and the focus would return to rate hikes and combatting inflation.
Scenario 2 would see no quick resolution to the conflict and an escalation of sanctions, perhaps also with some retaliation from Russia. Commodity prices would remain highly elevated and could rise further if oil and gas supplies to Europe were eventually cut. The world would be facing a commodity price shock that could have a material impact on economic growth, consumer confidence and the inflation outlook. Scenario 2 has quite a wide bandwidth of outcomes in our opinion and we think would have the greatest growth impact on Europe, with growth potentially falling anywhere from 1% to 4% from prior forecasts. Inflation across the world would continue to soar, perhaps touching 10% in the UK and the US, and not tailing off anywhere near as quickly as central bankers were predicting as we entered 2022. At the tamer end of the Scenario 2 spectrum markets would most likely rally, but at the worst case end recessionary conditions would prevail. It is hard to tell what type of recession this could be, but at this juncture we would predict a V-shaped one, since we would expect the solution to this recession would involve governments making efforts to reverse the commodity price shock and changing trading partners. We would also expect a swift and coordinated fiscal and monetary response, probably including subsidies to dampen the blow of higher commodity prices.
Scenario 3 is by far the worst and would include an escalation of the military conflict, perhaps with Russia launching further invasions and drawing other nations into the war. The market response to Scenario 3 would likely be similar to the most severe end of Scenario 2, but with more grave consequences.
Geopolitical crises are very hard to predict and equally hard to trade. In our view we are likely to end up somewhere in the middle of the spectrum of Scenario 2, which I would call our tentative base case. In that event, we would be confident of seeing higher inflation and equally confident of a slowdown in growth. However, markets look to have already priced a lot of this in, and in some areas we think they have priced in more negative consequences than our base case. Consequently, with a medium term view, from today’s levels we think many areas of the corporate debt markets look attractive. In the short term it is obviously hard to predict how the market will swing, but to us today’s elevated yields are compensating for a lot of bad news and it is worth highlighting a few examples.
The ICE BofA Contingent Capital (Coco) index, which tracks subordinated bonds from banks and insurers, is now showing a yield of nearly 6% – its all-time high, achieved in March 2020, is 7.4%. The European high yield index now yields around 4.7% (its 10-year historical average is 4% and it was 2.29% six months ago), while the equivalent US high yield index has also moved sharply higher, from yielding 3.78% in September to close to 6% now; obviously these need to be currency hedge adjusted to directly compare them with each other. The yield on BB rated European collateralised loan obligations (CLOs), historically one of our favoured sectors and almost exclusively a floating rate asset class, is now approaching 800bp over the risk-free rate having been at around 650bp at the start of the year.
For a good demonstration of how far markets have moved, the yield on our unconstrained Strategic Income strategy (using GBP yields for comparison) is now 6.43%1. It was 6.75% in March 2020 at the peak of the market turmoil caused by the outbreak of the COVID-19 pandemic, and 6.58% at the peak of the energy price crisis that roiled markets in February 2016. In each of these cases we had shortish duration by historical average, a strong pull-to-par, high yield and liquidity with which we could aim to tilt the portfolio towards what we thought would be a strong recovery. Admittedly it is harder to predict the bottom this time, but in the medium term we are confident that spreads will compress again and that yields will be lower in the future.
Today’s portfolio is full of what we consider to be strong credits and we have no direct Russian exposures. Due to our previously held inflation concerns we have put extra emphasis on lending to companies that we see as having strong pricing power and therefore able to pass the looming input price rises on to their customers. Our outlook for those without pricing power and high commodity price inputs is that they likely suffer profit margin pressure and increased leverage, and it is here that we believe future downgrades will likely be most prevalent. These are companies we want to avoid in all of our scenarios.
We must stress that we remain very confident in our bank exposures; the group of banks we cover has never held this much capital, and is still holding the excess that it built up during the worst of the pandemic. Russian and related exposures at these banks are very low and in our view very manageable in the context of this excess capital, especially so having very recently witnessed how banks performed through the deepest recession on record. This is a sector that we would most likely look to add to with our current 20% liquidity allocation. Given the back-up in US credit spreads that we thought expensive relative to historic averages, this would be another area that we would anticipate adding to given their strong economic position and lower reliance on energy imports versus some of their counterparts in Europe.
The case for holding floating rate assets is still strong in our view even if the central banks stall their hiking later this year due to a slowdown in growth, so we will most likely look to our CLO exposure as well while the spreads on offer are at or close to current levels.
Finally, and unusually for a period of uncertainty, we are still not expecting to add any rates duration. This is a real conundrum for fixed income investors with higher inflation pulling yields higher but slowing growth dragging them down again. The typical risk-off appeal of government bonds has been clouded by the ever-rising inflation outlook, making them less reliable than usual as a safe haven asset in our view. In the short term at least our preference would be to own the shorter end of the government curve where we think rate hikes are already baked into the price and may not all materialise.
All told, we are still facing a lot of uncertainty and while we could see an outcome that is possibly worse than is currently being predicted, in our view a lot of bad news is already priced into the market. We think investors will be rewarded for their patience in these testing times. As always we are disappointed to have drawdowns during this period but once again we are fortunate to be running with such high levels of liquidity, which means we can look to quickly tilt portfolios towards the upside when the recovery comes.
We will continue to update you on our views as frequently as possible through our regular blogs and would encourage you to keep your questions flowing as they are often as useful to us as they are to you.
1. Based on a representative portfolio selected as the oldest and most representative account.
