Recession and fragmentation

Market Development: On 15th June, the Fed increased its Fed fund rate by 75bp and opened the door for another 75bp hike on 27th July. This very hawkish stance is due to persisting high inflation (+8.6% YoY) in a very strong labour market environment.

Commentaire du Fonds
19 Juil 2022

Market Development: On 15th June, the Fed increased its Fed fund rate by 75bp and opened the door for another 75bp hike on 27th July. This very hawkish stance is due to persisting high inflation (+8.6% YoY) in a very strong labour market environment.

In Europe, the Swiss SNB took the market by surprise with a 50bp rate hike. The ECB has not moved at this point, but its objective to act soon pushed up peripheral yields. A spectacular widening of the spread in Italy prompted Mrs Lagarde to consider a set of anti-fragmentation tools.

The credit market continued to suffer. As Investment Grade spreads began to stabilise, the hybrid corporate bond market experienced a massive sell-off in June, opening the door to investment opportunities not seen since the 2009 crisis.

Market Outlook

Our outlook will focus on the behaviour of the Fed and the ECB. They will be key drivers in the evolution of the markets. In the current environment, it’s likely that growth will decline and inflation will slightly increase or stabilise at very high levels. As a result, more than ever, we will continue to focus on the macroeconomic situation (including growth, inflation and unemployment), Central Banks’ behaviour and the evolution of equity markets.

The main message from the markets is that the fixed-income bear market is not over, but we are probably close to the bottom, which is already a good entry point. A monetary policy mistake made by a major central bank, such as the Fed or the ECB, due to overly aggressive tightening, seems more and more likely.

We believe that the Fed is aware of the problem and will make a mistake intentionally. The measures will kill inflation, but indirectly as they will lead to a recession and inflation will eventually decrease sharply due to that recession.

An aggressive Quantitative Tightening policy combined with a series of rate hikes seems inappropriate. The problem is that central banks have no choice but this one. The Fed mentioned that the second phase of its strategy (from neutral to restrictive) would start after September. The Mid-Terms will be in November. These two events combined will probably lead to a recession after November.

Long-dated US Treasury yields will continue to suffer in the short term, but could become more attractive should they reach key levels, around 3.20%-3.30%. We will avoid high beta credit risk in general and we do not intend to invest in Emerging Markets in this uncertain environment.

In terms of portfolio management for the coming weeks, we will continue to follow our strategy but will avoid tactical short-term positions. Should the 30Yr Treasury yield continue to climb, we would increase our position in order to protect our credit portfolio with this natural hedge, but this is not our priority.

Our main objective is to abandon our duration overlay policy and depending on the behaviour of 10Yr Treasury yields, we will consider reducing (partially or totally) our short 10Yr Note future position. Should the Fed make a policy mistake, the sweet spot on the US Treasury yield curve could be the 5Yr, which was added to the portfolio in May 2022.

As a result, we believe that the best strategy today is to avoid portfolio turnover and maintain exposure to a selection of high-quality corporate bonds, both in EUR and USD. Hybrid debt has suffered recently but is becoming a strong buying opportunity, which has become more attractive than during the worst period of the COVID pandemic, in March 2020.

High-quality credits are probably the sweet spot and we will keep our existing position due to the generous carry of the spreads. Now more than ever, active management of the four pillars of our strategy is key to protecting our portfolio in the short-term bear market and delivering a robust performance in the medium and long term.

Portfolio Development

In June, we increased the duration of the Strategic Bond Opportunity Fund with a significant reduction of our short position in 10Yr Note Futures. In the Investment Grade sub-portfolio, we took a rare opportunity to buy a 5Yr Air Liquide, yielding above 4%.

 

As always, we invite investors and prospective investors, to contact us should they wish to understand our views on the current situation and the positions held in the portfolio. Please do not hesitate to contact us for further information.

Adam TurbervilleAdam Turberville
Director
+44 1481 742380
a.turberville@ericsturdza.com

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The views and statements contained herein are those of Banque Eric Sturdza SA in their capacity as Investment Advisers to the Fund as of 12/07/2022 and are based on internal research and modelling. Please click on Disclaimer Page to view full disclaimers.