COVID, inflation and central banks behaviour

First and foremost, the COVID pandemic is a persistent concern and the dangerousness of the Omicron variant is unknown as we write this, despite possible good news from the efficacy of mRNA vaccines. The Delta variant is still active in Europe and it is impossible to foresee the emergence of new variants in 2022.

Fund Commentary
13 Dec 2021

First and foremost, the COVID pandemic is a persistent concern and the dangerousness of the Omicron variant is unknown as we write this, despite possible good news from the efficacy of mRNA vaccines. The Delta variant is still active in Europe and it is impossible to foresee the emergence of new variants in 2022.

Since October, the WHO has stated that it is too early to consider that the pandemic is no longer a threat, and the Fed has listed COVID above inflation in its ranking of major risks. We suspect that central banks are reluctant to significantly amend their monetary policies until they are sure that the sanitation situation improves.

Inflation is obviously the big question mark. We are convinced that inflation will gradually slow down in 2022. “Transitory” is now a taboo word because the Fed is not able to forecast the starting point of the decrease of consumer prices. We keep in mind that, against all odds, the Bank of England (“BoE”) recently took a totally unexpected decision.

A rate hike was unanimously anticipated by the markets, as inflation in the UK is increasing dangerously and because the mandate of the BoE is very clear on this topic. The BoE should have raised its key rate. This rate hike has been postponed because the BoE believes that the current slowdown of economic growth in the UK is a more significant source of concern than a spike in inflation.

We believe a rate hike in the current environment would have been a monetary policy mistake. Everybody has been taken by surprise; however, this has been our view since the Jackson Hole meeting in August, that markets pay too much attention to inflation and forget that growth is declining at the same time. We are convinced that inflation will decrease gradually, it will take longer than we initially thought, but our major source of concern for 2022 is a global slowdown, led by a probable recession in China.

For the first time, a central bank mentions and corroborates our view, the biggest surprise for us is that we could never have imagined that the central bank would be the BoE. Our outlook for economic growth in Q1 2022: higher commodity prices; the potential damages of the collapse of the Chinese high yield market (led by Property); and the shortage of components affecting different industrial sectors; all need to be considered in order to adapt our strategy for the early part of next year.

In this environment, a Fed monetary policy mistake is more and more likely in 2022. Jerome Powell has been confirmed by Biden-Yellen as Fed Chair for a new mandate of four years. We think that this appointment is the result of negotiations between Yellen and Powell. His mission will be to fight aggressively (more aggressively than previously anticipated) against inflation in order to stop the escalation before the Mid-Term elections. It means that the Fed will become more hawkish, and two rate hikes are probably the central scenario for next year.

In addition, tapering could be amended with a faster pace of reduction in purchases. The Fed will make this mistake because instead of modelling their policy on the BoE, they will follow the Biden administration scenario, thinking that inflation is, as of now, the number one threat. The message sent by the BoE did not cross the Atlantic! In Europe, the ECB should stay ultra-accommodative despite higher inflation.

The PEPP will be replaced by another acronym and the total amount of asset purchases will not decrease substantially. The Eurozone cannot afford a real tapering. More importantly, we have always thought that all the Quantitative Easing policies must be considered at a worldwide level.

In China, in order to fight against a possible recession, the PBoC will be ultra-accommodative in 2022. It means that the global amount of asset purchases from central banks in 2022 will not decrease – and could even increase. Given the huge amounts put on the table by the Chinese central bank, the Fed tapering is not a major threat.

What does it mean in terms of portfolio strategy for 2022? Against the consensus, we believe that the behaviour of the Fed will lead to a flattening of the US yield curve instead of a steepening. Long-dated US Treasury yields are already decreasing and we are still looking for new entry points to increase the duration of the portfolio when we have the opportunity to buy more long bonds on any weakness.

Some high-quality emerging markets could offer investment opportunities, driven by demand, but for the time being, they still appear too risky and uncertain, Latin America and China in particular. As a result, we still believe that the best strategy to start the year off is to invest in a selection of high-quality corporate bonds, both in EUR and USD, favouring USD Investment Grade. Hybrid debt is expensive: the objective is to keep the existing position for the carry of the spread, but not increase the weight of this asset class until there is a major correction in the equity markets, which is not certain but still possible.

High-quality credit spreads are attractive in the current environment, but our main objective during the first quarter of 2022 is to gradually increase the duration of the portfolio through the purchase of long-dated US Treasuries in order to protect the Strategic Bond Opportunities Fund against the increasing threats mentioned above, which could affect the markets in early 2022. In other words, a bit less credit risk and a bit more duration through 30y Treasuries will be the key drivers of our strategy in the coming weeks.

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 09/12/2021 and are based on internal research and modelling. Please click on Disclaimer Page to view full disclaimers.