Market Review
Global fixed income subsectors generated positive returns during the first quarter, benefiting from a plunge in most developed market sovereign yields in response to stresses in the banking sector. Market repriced expectations for policy rates, forecasting a more dovish approach in order to maintain systemic financial stability. Most credit sectors generated positive excess returns as regulators took steps to boost liquidity and provide reassurances about the health of the banking system. However, securitized sectors underperformed driven by concerns about forced sales of banks’ securities holdings (agency mortgages) and impact of banks stress on the commercial real estate market. the US dollar versus most currencies.
Global growth weakened across most developed market economies during the fourth quarter as the lagged impact of tighter monetary policy started to take effect. Inflation remained well above central bank targets, supported by still tight labour markets. US payroll growth remained firm, though the unemployment rate ticked up as more workers entered the labour force. Inflation in the UK printed close to the highest levels among developed market economies even as house prices declined further. Services PMI expanded in the euro zone, boosted by real estate activity, while manufacturing PMI contracted for the 9th consecutive month. Japanese retail sales rose more than expected, led by clothing and car; inflation ex-fresh food and energy rose by the most in over four decades. China's recovery gained steam as both manufacturing and services PMI's expanded by more than forecast.
Volatility spiked, particularly during March, after the collapse of Silicon Valley Bank (SVB) let to fears about broader contagion across the banking system. Swiss authorities stepped in with a negotiated Credit Suisse-UBS deal to restore the confidence. Policy makers respond promptly to the banking crisis and there was a surge in borrowing at the Fed’s emergency discount window and U.S. dollar swap line facility. Emphasizing a separation in their financial stability and monetary policy toolkit, major central banks delivered hikes in line with consensus despite concerns over their impact on the banking industry.
Major bond yields decline as a result of a flight to safety and a dovish repricing of the Fed Funds rate. US rates ended lower as markets priced in Fed rate cuts in 2023 even as inflation remained above target and economic activity appeared resilient. Most eurozone and UK rates also declined.
Performance Review
During the quarter, the Fund series F generated total return of 4.18%, outperforming the Bloomberg Global Aggregate CAD Hedged Index which generated 2.76% total return. All three components of the portfolio contributed, with Strategic Sector, Market Neutral, and Tactical each posting positive returns.
The portfolio was well positioned heading into the SVB failure. The team had believed that financial conditions were very tight in the United states and that the market was too passive to the probability of a hard lending. While the team did not anticipate the crisis, they had moved a considerable amount of duration to the front end of the yield curve within their tactical strategies, which benefited as market repriced the path for the Federal fund rates. In addition they maintain high level of duration in the portfolio within the Strategic Sector positions across the Activist Government and Core Challenges themes. Finally the portfolio’s Credit Relative Value strategies were defensively positioned holding significant short positions in high yield and emerging market debt ahead of the events and generated strong returns for the quarter.
Strategic sector positions generated the strongest contribution to total return as preference for interest rate exposure across both developed and emerging markets versus most corporate spread exposure generated strong returns as market repriced forward-looking economic performance and central bank reaction functions. The fund’s Market Neutral strategies and Tactical strategies were well placed to monetize the large swings in interest rates and credit spreads experienced during the quarter. Within the Credit Relative Value strategies, the team took advantage of attractive valuations across hybrid/preferred markets early in the quarter eliminating these positions as valuations moved to fair value. At the same time, the team held significant short positions across emerging markets debt and select corporate sectors which performed strongly as spreads widened. Similarly, within the Tactical strategies the team began increasing exposure to short end rates globally in anticipation of a weaker economic cycle which performed strongly as market repriced. They were encouraged that as in the fourth quarter of 2022 all three components of the portfolio contributed to performance. Since the end of the second quarter of 2022, the private pool has generated positive returns outperforming its benchmark significantly.
Positioning and outlook
In the midst of the turmoil of March, the team made a number of changes to the portfolio to take advantage of bond market volatility they had not seen since Covid and the GFC beforehand. The team sold a portion of their front-end US rates positions as the market at one point priced in almost 100bps of cuts by the Fed within the next few months. They replaced this duration into 5y US real yields and current coupon Agency Mortgages. The portfolio weight to Agency Mortgages is currently 22%, the highest exposure to the asset class since the pandemic. Implied interest rate volatility had reached its highest level since the GFC, but given the SVB news the team has more certainty over the eventually end of the Fed’s hiking cycle and would expect some decline from interest rate volatility from here benefitting current coupon agency mortgages.
The Credit Relative Value strategies also took advantage of the volatility to close out their shorts in US high yield bonds at attractive levels. Within Strategic Sectors, the team added to Capital Securities allocation within our Stranded Credit theme. Capital securities were unfairly maligned in the aftermath of the Credit Suisse failure as many other managers had heavy exposure to contingent convertible bonds within their Capital Security allocations. The team used this opportunity to increase their exposure to the asset class.
The fallout from the SVB failure changes the labor market outlook significantly. The team does not believe the regional bank liquidity problems are over. When the debt ceiling gets passed, the Treasury will need to raise its balances at the Fed, which will remove reserves from the system while Quantitative Tightening (QT) continues. While there may be enough system-wide liquidity, where that liquidity sits matters and regional banks do not have excess reserves. Even if the bank runs subside as we all hope, the cost of credit is still going up substantially in the economy as regional banks still have a substantial earnings problem. Smaller companies, which have been the bedrock of the strong labor market, will likely find their credit constrained. The team would expect that this increase in cost of capital will lead to job losses in excess of what the market anticipates.
Corporate balance sheets are strong and defaults will be low - many market participants currently believe that the US corporate sector is quite healthy, with strong balance sheets, stable leverage ratios, ample interest coverage, and robust free cash flow levels. The latest data supports this belief, and many companies did in fact use the low-rate environment of 2020-2021 to term out debt. However, much of the available free cash flow can be traced to a lack of capex investment over the past decade, as well as companies holding off on further spending until inflation ebbs. It seems unlikely that companies can continue to focus on debt-financed share buybacks in lieu of capex in a deglobalizing world of higher interest rates.
Most investors look at BBB-rated companies with roughly 3x leverage and net-debt-to-enterprise values of 33% and see no reason for concern. However, research suggests that corporate profits could fall 15%-25% during the next recession. If multiples were to contract similarly, then your typical BBB-company would start to look more like a BB-risk. For high-yield companies, this math would be even worse.
The team maintains high levels of duration relative to the portfolio’s historic ranges, and it is well diversified across inflation-linked bonds (ILBs), core challenges, DM government bonds and EM local debt. Given the team’s view on inflation surprising to the downside, it is reasonable to ask why they are maintaining the exposure to ILBs. The decline in inflation expectations is already in the price for most TIPS with most forward breakevens trading below the Fed’s 2% long-term inflation target. In addition, the biggest risk to the team’s negative view on the economy is that the US consumer continues to draw down savings maintaining inflation. ILBs provide some hedge to this scenario as well as to an overall rise in commodity prices that could occur due to increased geopolitical tensions.
The team maintains overall low levels of credit risk relative to the portfolio’s history. With spreads at their median historical percentile and the team’s negative view on the US economy, they feel that taking advantage of high levels of dispersion in credit markets through the portfolio’s credit relative value strategies is the more prudent course of action. Finally, they are maintaining their negative US Dollar positioning. Many investors tend to believe that if the we enter a US recession you should buy the US dollar, particularly if volatility spikes and stocks sell off. However, the team believes the 15-year US dollar (USD) bull market may have ended in September 2022. The USD has historically tended to move in such long cycles, but often with little correlation to equity performance and market volatility. Past examples of USD underperformance despite financial market weakness include the 1970s, Black Monday (1987), the 1994 Fed hiking cycle, and the bursting of the tech bubble (2000).
