Market Development: December started with a continuance of the very strong Non-Farm payrolls figure with 263,000 job creations (and the prior month was revised to 284,000). As we have already mentioned, these numbers are still far from 150,000, which is a leading indicator of a turning point towards recession. The inflation figures were encouraging but offset by disappointing PPI data.
As a result, the last FOMC of the year was a non-event, both in terms of rate hikes and communication. Due to the robust economy (GDP and unemployment) and an overly slow decrease of inflation, the Fed will not stop its restrictive monetary policy immediately.
We mentioned last month that November was strong in terms of performance and the recovery of bond markets (both governments and credits), which actually began on 20th October. This unexpected rally continued in early December, however, markets later turned negative suddenly on the back of two major events outside of the United States.
In Europe, the very hawkish tone of the ECB has taken the markets by surprise. Nobody can deny that inflation is very high in the Eurozone (much higher than in the US), but the risk of a deeper recession is likely, should the ECB become too aggressive.
In Japan, the BoJ has also taken us by surprise with an easing of its Yield Curve Control policy, allowing the 10Yr JGB to fluctuate in a larger band than previously. Japanese bond yields climbed dramatically, with a significant impact on the German Bund and, to a lesser extent, US Treasuries.
More than ever, we continue to follow the macroeconomic situation and geopolitical events and conflicts very closely. Inflation is still very high, but recession fears have become the main concern.
The behaviour of the Fed towards rate hikes and QT is an issue as many investors, and some FOMC members, believe the Fed is going too quick and too far.
We do not have any strong conviction on the famous level of pivot rate because we still believe this debate is partially irrelevant, as we don’t know the behaviour of the central bank towards the pace of QT; which is at least as important as the level of Fed funds (perhaps more).
Should the Fed remain reluctant to be clear on the combined effect of rate hikes and QT, a Quantitative Easing program is more likely than a series of rate cuts over a 12-month horizon. Should the recession become deeper than we expect, a Fed rate cut could be considered before the end of 2023, or in early 2024.
We believe that the US Treasury curve will remain inverted, through the 2-10Yr and, more importantly, the 5-30Yr. We are prepared to slightly increase the duration on any correction.
We will probably continue to invest in high quality-low duration credits, depending on the behaviour of Investment Grade spreads, which are highly correlated to the evolution of equity markets. At this stage, reinvesting in Emerging Markets seems unlikely in the near-medium term.
As a result, we believe that the best strategy today is to invest in a selection of high-quality corporate bonds, both in EUR and USD, favouring USD Investment Grade and keeping hybrid debt (both in EUR and USD). We are also considering increasing the duration slightly, depending on market evolution and central banks’ behaviour.
In terms of strategy and portfolio management, we will amend our philosophy slightly in 2023. We call it the 80-20 strategy. 2022 has been an annus horribilis for bonds, with their performance below our worst-case scenarios.
As a result, today, some corporate bonds can deliver a very decent yield. In a high-quality universe, we can assume that default risk is virtually non-existent or non-existent: it means that these bonds will pay the coupon and will be redeemed at par on their maturity date or next call date.
As an active Fund Manager, we have always managed the portfolio with a significant turnover in order to optimise the expected return and performance. Today, we firmly believe that around 20% of the portfolio is composed of bonds that must be kept in a “buy and hold” strategy.
Eventually, their price will converge to 100. It is not “if” but “when”. We will obviously stay very active in terms of duration and credit spread management with the remaining 80% of the portfolio, but we have a strong conviction that this 80-20 strategy is the best behaviour we can adopt with the interests of our shareholders in mind.
In December, we didn’t change our strategy and we did not trade any securities in order to stabilise the portfolio, avoiding any costly turnover. In addition, liquidity is always poor during December and it is better to reduce trading activity if possible and to postpone any purchases or switches to January.
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.
+44 1481 742380
The views and statements contained herein are those of Banque Eric Sturdza SA in their capacity as Investment Advisers to the Fund as of 05/01/2023 and are based on internal research and modelling. Please click on Disclaimer Page to view full disclaimers.