Inflation or recession? Or both together?

Market Development: November began with a frustrating FOMC meeting. The 75bp rate hike was unanimously expected and markets were waiting for signs of relief in Jerome Powell’s speech. The Fed affirmed that inflation is still high, the US economy is robust and the labour market remains very strong.

Fund Commentary
21 Dec 2022

Market Development: November began with a frustrating FOMC meeting. The 75bp rate hike was unanimously expected and markets were waiting for signs of relief in Jerome Powell’s speech. The Fed affirmed that inflation is still high, the US economy is robust and the labour market remains very strong.

As a result, it has been difficult to imagine a less hawkish central bank for the weeks ahead. In our view, this speech was frustrating because Jay Powell did not give any details regarding two major issues:

Firstly, the lag effect between rate hike decisions and their impact on the real economy;
Secondly, the consequences of a continuing Quantitative Tightening (QT) policy.

In terms of economic data, the Non-Farm Payrolls were, surprisingly, still very strong with 261,000 job creations (and the prior month revised to 315,000). We are still far away from 150,000, which is a leading indicator of a turning point towards recession.

The CPI figures were encouraging with +0.4% MoM and +7.7% YoY, and “only” +6.3% ex-Food & Energy. These better inflation statistics were confirmed by a softer PPI.

November was a strong month in terms of performance. The recovery of bond markets (both government and credit) actually started on 20th October. This unexpected rally, led by hybrid corporates, allowed the Fund to deliver a robust +2.82% performance in November.

Market Outlook

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 do not 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 9-12 month horizon. Should the recession become deeper than we expect, a Fed rate cut could be considered before year end in 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.

Portfolio Development

In November, we did not change our strategy and only sold a few US Treasuries maturing in 2023 to monitor the cash position.

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 20/12/2022 and are based on internal research and modelling. Please click on Disclaimer Page to view full disclaimers.