A hawkish ECB and then… the war

Market Development: Up to the 24th of February and the Russian invasion of Ukraine, the key driver of the markets was the sudden evolution of the behaviour of the ECB towards inflation.

Fund Commentary
9 Mar 2022

Market Development: Up to the 24th of February and the Russian invasion of Ukraine, the key driver of the markets was the sudden evolution of the behaviour of the ECB towards inflation.

A slightly more hawkish policy was anticipated, but this very aggressive U-turn surprised the markets. European government bond yields and credit spreads increased significantly. In addition, peripheral spreads widened, led by Italy, but the most weakened market was undoubtedly the Hybrid corporate universe, delivering a more negative performance than High Yield and European equities.

This European bear fixed income market also affected the evolution of US bond markets. Then, on 24th February, an unthinkable event suddenly occurred: a war in the heart of Europe!

Global financial markets began to fluctuate with high volatility, depending on the flow of bad news and (slightly) better news. Uncertainty prevailed: this war could lead to a recession, but inflation could rise sharply due to commodities such as oil and gas, but also wheat. Fixed income markets fear stagflation, but this could be the best-case scenario.

At this stage, the big question was the evolution of central banks’ monetary policies, but they did not comment publicly on the impact of the war on their hawkish stance. This will be a major topic in March, obviously after the evolution of the conflict itself.

Market Outlook

Our outlook will focus primarily on the evolution of the war in Ukraine and its potential damages on the US and European economies. The behaviour of the Fed and the ECB will be key drivers in the evolution of the markets. At this stage, the consequences of this conflict on Western economies is highly unpredictable. Growth will probably decline, but simultaneously, inflation could sharply increase.

A worst-case scenario could favour safe havens such as gold, Swiss Franc and US 30y Treasuries. 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 COVID pandemic seems to be over, but we will keep an eye on the evolution of variants: an unwelcome surprise is unlikely, but not totally out of the question.

A monetary policy mistake by a major central bank such as the Fed or ECB due to overly aggressive tightening is looking more and more likely, and their attitude towards the war in Ukraine will be the first test.

In the US, long-dated US Treasury yields are becoming more attractive and we continue to look for new entry points to increase the duration of the portfolio if we have the opportunity to buy more long bonds on any weakness. Generally, we will avoid credit risk and emerging markets in particular, 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 bets. Should the 30y Treasury yield continue to climb, we would increase our position in order to protect our credit portfolio with this natural hedge. If the situation worsens in Ukraine, depending on the behaviour of 10y Treasury yields, we could consider a decrease of our duration overlay policy.

As a result, we believe that the best strategy today is to keep our investments in a selection of high-quality corporate bonds, both in EUR and USD. Hybrid debt has suffered recently, but the bear market in this asset class could continue.

High-quality credits are at risk, but we will keep our existing position due to the generous carry of the spreads. 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 to delivering a robust performance in the medium and long term.

Portfolio Development

After a very intense January with a significant decrease in hybrids and emerging markets, we were less active in February.

We decreased the weight of two hybrid bonds: Vodafone (due to increasing pressure from activist shareholders) and Repsol (cautious stance after an oil spill in Peru).

We incrementally added a few 30y Treasuries and increased the duration overlay of US Investment Grade credits, doubling the short position in 10y T-note futures.

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 07/03/2022 and are based on internal research and modelling. Please click on Disclaimer Page to view full disclaimers.