USA-China: the hawks and the doves

Market Development: In January, the two key drivers of the markets were: the Fed’s release of the December FOMC minutes; and the decision of the PBoC (People's Bank of China) to initiate a series of rate cuts.

Fund Commentary
21 Feb 2022

Market Development: In January, the two key drivers of the markets were: the Fed’s release of the December FOMC minutes; and the decision of the PBoC (People’s Bank of China) to initiate a series of rate cuts.

The Fed mentioned its ambition to shrink the size of its balance sheet after one or two rate hikes, once the tapering is over. This behaviour – more hawkish than anticipated by the markets, was not welcome, but the sell-off in the bond market did not materialise. The Chinese decided to adopt a more dovish monetary policy to combat a possible slowdown.

The release of the US CPI reaching a record level at 7% didn’t really change the behaviour of the fixed income markets as it was largely anticipated.

Due to the global increase of yields, the number of negative-yielding bonds decreased sharply for both governments and credits (except in China), reaching the pre-pandemic levels. The other consequence of this global increase of bond yields is the probable end of TINA (There Is No Alternative), a strong argument to favour equities at the expense of bonds in recent years.

Market Outlook

Our outlook will continue to focus on the macroeconomic situation (including growth, inflation and unemployment), Central Banks’ behaviour and the evolution of equity markets, which could be more volatile in the coming weeks.

The COVID pandemic seems to be over, but we will keep an eye on the evolution of variants: an unfortunate surprise is unlikely, but not totally excluded.

Inflation fears in the US and Europe remain high and are still growing, but a global slowdown scenario, led by a sharp drop in the Chinese GDP is becoming more likely in the second half of the year.

The main concern is the behaviour of the Fed and the ECB. The Fed was too “behind the curve” in Q4 2021 – and probably too hawkish now. A monetary policy mistake due to a too aggressive tightening is more and more likely. The ECB could be a bit more hawkish, but an overly aggressive U-turn could be a disaster as the economic situation in Europe is not as strong as in the US.

In the US, long-dated US Treasury yields are becoming more attractive. 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.

We will avoid Emerging Markets for the time being in this uncertain environment. We will not add credit risk in the coming weeks, instead of waiting for better opportunities when spreads widen.

Our strategy for the coming weeks is simple: should the 30y Treasury yield continue to climb, we will increase our position (but it would be in homeopathic doses). Should the 10y Treasury yield decrease, we will take the opportunity to short more 10y note futures in order to partially hedge the duration of 7-10y Investment Grade credits (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.

After having decreased our exposure to hybrids, we will keep the remaining positions for the carry of the spread, waiting for an increase of the weight of this asset class, once we believe that we are approaching the end of a major correction.

High-quality credit spreads are still attractive in the current environment because the carry has increased sharply. 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

In January, we were very active in the four markets that constitute the four pillars of our strategy and we greatly decreased the credit risk of the portfolio.

In the USD Investment Grade and hybrid markets, we decreased the weight of Italy 2029, NY Life 2028, Unicredit 2022 and BP hybrid. In the USD Emerging market, we sold Bimbo hybrid, Romania 2031, Alibaba 2027 and Perusahaan Penerbit (Indonesian government-related issuer) 2030.

In the Euro credit market (hedged in USD), we sold our remaining stake in Renault 2028 and decreased the weights of the Veolia hybrid and Repsol hybrid. In the US Treasury market, we continued to favour our barbell strategy, investing in both very short and very long bonds, maturing in 2023 and 2051.

Finally, yet importantly, in order to decrease the overall duration of the portfolio without selling, or sacrificing, our favourite Investment Grade credits with maturities of 7 to 10 years, we partially hedged their duration with a short position in the 10y Note Future, reinitiating the duration overlay policy we abandoned during the COVID crisis.

It is also important to notice that the decrease or sale of Bimbo, BP, Perusahaan Penerbit and Alibaba allows us to significantly improve the ESG quality of the portfolio.

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 18/02/2022 and are based on internal research and modelling. Please click on Disclaimer Page to view full disclaimers.