BY ERIC VANRAES
First and foremost, the current volatility is not exceptional; however investors have forgotten how markets really behave when they are not manipulated by central banks due to their quantitative easing policies.
The cause of the recent volatility is “officially” the resurgence of fears of inflation, but this was probably a pretext. On 2nd February the average hourly earnings rose to 2.9% (annualized) and market participants immediately modified their inflation projections and revised their Fed funds forecasts. Eric Vanraes, Portfolio Manager to the Funds believes that it is too early to draw conclusions regarding inflation. The Investment Adviser still believes that this kind of revision is normal and does not mean that wages will grow significantly in the US. Inflation will be driven by long term trends such as demography and digitalization of the economy.
In addition, Developed Markets shifted from an industrial economy to a world of work dominated by services. In the short term, wages could continue to increase slightly because some readjustments are necessary in the US economy led by full employment. In addition, a weak dollar could push imported inflation higher. The answer will come from the behaviour of central bankers. Mr. Powell, Chairman of the FED will probably stay very cautious in order to avoid another wave of volatility and fear in the bond market. US Treasury yields have risen significantly, causing a correction in equity markets. “We are probably close to the top and opportunities will have to be seized in the near future, probably around 3% and 3.25% for the 10 year and 30 year notes respectively” in the Investment Adviser’s view.
The financial markets probably over-reacted in early February and the wages data is probably a pretext for a natural and sound correction for equity markets. The Investment Adviser is confident that US yields are close to a top but another wave of corrections is possible. Should this correction take place, it would not be driven by macroeconomic data but by flows. In the team’s opinion, the biggest risk today in the bond market is the level of issuance of Treasuries in 2018. In Eric’s opinion, this is a consequence of Mr. Trump’s tax reform. The US Treasury Department issued USD 488 billion last year but will need to issue more than one trillion in 2018. Until now, the two major buyers of Treasuries were the Fed and the Chinese… Let’s imagine that one auction goes wrong and it prompts Treasury yields to rise higher. That could be a fantastic opportunity for investors to increase their fixed income allocation for the first time since 2013.
The team’s long term strategy has not changed; however they have modified substantially short term positioning in the Fund’s portfolios. Since 31st January the Investment Adviser anticipated the correction following Mrs. Yellen’s speech (her last one) in which she mentioned higher wages and a probable impact on the Fed’s inflation forecasts. The publication of NFP data on Friday 2nd February confirmed her thoughts. As a result the team implemented a more aggressive duration overlay policy and the modified durations of the funds have been decreased dramatically, from 1.9 to 0.8 for the Strategic Euro Bond Fund, from 5.4 to 2.6 for the Strategic Global Bond Fund and from 5.3 to 2.8 for the Strategic Quality Emerging Bond Fund. As a result, YTD performances of the two US dollar denominated funds are negative, around -1.7%, in line with a total return approach while the performance of our Euro Bond Fund is flat or slightly positive, driven by a short position in the Bund future, in line with the Fund’s absolute return philosophy.
In the euro market the team is very cautious. The Bund still has room for another wave of correction and corporate spreads should underperform significantly in the coming months in their view. They will suffer from two major factors which will drive their behaviour in 2018: their correlation to equities and the probable tapering of the ECB’s monetary policy from September. As a result, the Investment Adviser will not add more credit risk to the portfolio and will keep duration risk very low. The objective will be to maintain the performance around 0%, slightly above if possible. In the two US dollar denominated funds, the team will consider decreasing the short future position gradually once the 10y note approaches 3% and the 30y long bond 3.2%. The team strongly believes that US treasury yields cannot move higher as it would mean an increased risk of slowdown for the US economy in 12-18 months. In the Global Bond Fund, they will progressively focus the strategy on long dated US treasuries and in the Quality Emerging Fund they will try to seize opportunities to switch partially low beta names into some high beta issuers, depending on the behaviour of these high beta names which, in the short term, could suffer from risk aversion.
Since June 2017, the team have in their monthly commentaries, noted that the Global Bond Fund could be the best investment in 2018 as the team perceive opportunities in the long US Treasury market. The team believes the time has come. Regarding the Euro Bond Fund, the team remain confident that their robust investment process and risk model will bear fruits in this more difficult environment. They have proven in this real -not virtual- stress test that the absolute return philosophy is capable of delivering stability and positive returns to investors. Finally, the Investment Adviser’s view is that the strategy in Emerging Markets, predominantly invested in Investment Grade issuers, will probably be more successful this year as low beta names will outperform in this market environment, driven by risk aversion.
The views and statements contained herein are those of the Eric Sturdza Banking Group in their capacity as Investment Advisers to the Fund as of 12/02/18 and are based on internal research and modelling.