Inflation, inversion, recession

Market Development: In April, the US yield curve experienced a series of inversions (mainly 2-10yr and 5-30yr) which are usually the first indicators that a recession will come in a 12-18 month horizon. Inflation was still the main issue for markets and central banks, more than the war in Ukraine and, to a lesser extent the lockdowns in China.

In the US, the PCE deflator was high and the Non-Farm Payrolls showed a US economy close to full employment. In this environment, the Fed continued to adopt a very hawkish tone. Lael Brainard, known until now as a dove, said the Fed will combine aggressive rate hikes and Quantitative Tightening in the near future, aiming to shrink the size of its balance sheet.

Market Outlook

Our outlook will focus on the behaviour of the Fed and the ECB. They will be key drivers of the evolution of the markets and apparently, their behaviour will not change due to the ongoing war in Ukraine.

In the current environment, growth should decline and inflation will probably increase slightly or stabilise at very high levels. As a result, now 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 given by the markets is that the fixed-income bear market is not over, but we could rapidly reach levels that could become good entry points. A monetary policy mistake made by a major central bank, such as the Fed or the ECB, due to a too aggressive tightening is looking more and more likely.

We believe the Fed knows the problem and will make a mistake intentionally. This is not traditional inflation and rate hikes will not be very useful. They will kill inflation, but indirectly because that 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.

In the US, 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 avoid tactical short-term positions. Should the 30y Treasury yield continue to climb, we would increase our position in order to protect our credit portfolio with this natural hedge.

Depending on the behaviour of 10y Treasury yields, we could consider a decrease in our duration overlay policy. Should the Fed make a policy mistake, the sweet spot on the US Treasury yield curve could be the 5y, which has been hammered recently.

As a result, we believe that the best strategy today is to avoid portfolio turnover and keep our investments in a selection of high-quality corporate bonds, both in EUR and USD. Hybrid debt has suffered recently, but they are becoming a buying opportunity we have not seen since March 2020 during the worst period of the COVID pandemic.

High-quality credits are probably the sweet spot and 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 deliver a robust performance in the medium and long term.

Portfolio Development

We did not modify our strategy in April, and due to high volatility and poor liquidity, we did not buy or sell any securities in the portfolio. Stability was, in our view, the best strategy to adopt in the current environment.

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 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 10/05/2022 and are based on internal research and modelling. Please click on Disclaimer Page to view full disclaimers.