Portfolio review
The reflationary dynamic in global financial markets began to stall in the latter half of June, after the U.S. Federal Reserve intimated that policy rates may rise sooner than expected. This coincided with what might be a peak in the upward rate of change in economic indicators, as the rapid spread of the highly infectious Delta variant disrupted plans to lift lockdowns and fully reopen economies. In some ways, investors seem to be reverting to the secular stagnation playbook that worked so well during the post-financial-crisis period. At that time, the Purchasing Managers’ Indexes (PMI’s) peaked and the second derivative of growth decelerated, signalling that it was potentially time to buy bonds and sell cyclicals.
Consequently, while the first quarter of 2021 featured the worst quarterly drawdown for the Barclays Aggregate Bond Index in the past few decades, the second quarter proved much kinder for most fixed income markets with positive total returns across most fixed income sectors for the quarter.
The portfolio realized positive total return contributions from all components of the portfolio during the second quarter.
Strategic sector positions were the strongest contributors over the quarter following significant declines in global interest rates and a tightening of credit spreads. Our Emerging Market Opportunities theme that featured a combination of exposures to external and local emerging market debt provided the largest positive impact as a combination of decreasing yields and underperformance of the U.S. dollar fueled returns from this asset class.
Positive contributors to performance within this component of the portfolio also included holdings in non-U.S. high-quality sovereigns, global-inflation-linked bonds, and U.S. high yield bonds. This, as inflation expectations began to normalize leading to a recovery of almost all fixed income sectors following the significant decline during Q1 2021.
Market neutral strategies contributed for the quarter as we realized positive contributions from long- duration positions that featured an overweight to U.S. and Australian interest rates. In addition, active currency positions that featured an underweight to the U.S. dollar also contributed as exuberance over relative growth expectations in the U.S. began to fade. Tactical strategies contributed favorably over the period.
Tactical sector rotation strategies were strongly positive as long positions in select emerging markets, bank loans and convertibles versus short positions in U.S. corporates contributed. This strategy benefitted as the EM, bank loan and convertible bonds recovered more sharply than U.S. corporates.
One of the largest contributors for the quarter were long duration positions in the U.S., Canada and Norway. We extended duration at the end of the first quarter believing that real and nominal government yields had moved too far too fast in repricing growth expectations. While we do believe that the policies enacted after COVID-19 do mean an end to secular stagnation, we always thought that the rise in yields would come more from the inflation expectations channel, rather than from the term premia (higher interest rates for long-term borrowers) channel. The latter is what happened in the first quarter. Consequently, we used the sell-off in real yields in the first quarter to add exposure to long-end Treasuries and TIPS. However, now with real yields having fallen back to a level we would consider fair, we are again less enthusiastic about rates broadly. And we have reduced duration in the portfolio accordingly, particularly our exposure to U.S. interest rates.
We believe we’ve entered a new macro era of higher and more volatile nominal growth and higher and more persistent inflation, underpinned by forces that are unique to this new business cycle:
- Fiscal policymakers show a strong commitment to maintaining high public sector spending through the post-COVID-19 recovery, in sharp contrast to the post-global-financial-crisis experience.
- From a monetary policy perspective, today central banks would rather be late than on time. They seem to see no cost in adding stimulus until economic slack is fully absorbed. In the second half of this year, global central banks are likely to buy another $1.5 trillion in assets.
- The acute labor shortages we are observing today will likely persist, reflecting the pull forward in retirements over the last year and the lack of immigration. This should manifest itself in higher wage growth over time.
Portfolio positioning
The regime we’ve been in for the last 30 years (and especially the last decade) of high, rising equity-spread valuations has been underpinned by stable and low inflation. Historically, we have found that inflation volatility has been highly negatively correlated to equity valuations. Low and stable inflation allows for loose monetary policy pushing down discount rates, and it also contributes to less uncertainty of macroeconomic outcomes which reduces risk premiums.
The recent surge in inflation in the U.S. has noticeably increased inflation volatility, though for now equity/spread valuations have continued to rise. While part of the volatility is related to bottlenecks that will eventually normalize, higher inflation uncertainty is also a direct consequence of the monetary/fiscal experiment that policymakers are pursuing.
This is one warning flag that we may be nearing peak valuations, especially for the U.S. where inflation uncertainty is highest in developed markets and where valuations are also highest. Indeed, U.S. equity valuations on most cyclically adjusted measures are now at or above the 2000 highs. What is most surprising is that these lofty valuations are coming at a time when the U.S. seems to be at the epicenter of an inflation overshoot. Over the course of Q2, core consumer prices rose 2.5%, which is more than the prior 19 months combined.
Consequently, we find ourselves increasingly disappointed with the return potential available from U.S. fixed income assets. U.S. nominal treasuries are not compensating investors for realized inflation that we believe will be stickier than the market currently thinks. At the same time, U.S. credit spreads are at their tightest level since 2007 despite much higher supply, longer duration, and worse credit quality. The Bloomberg Barclays U.S. High Yield index ended the quarter with a yield of 3.75%, which is in our view inadequate compensation for the volatility of the asset class as exemplified by March 2020. We are currently short U.S. investment grade credit and have also neutralized our high yield credit position as well.
The two biggest pushbacks we get to our view on the unattractiveness of U.S. assets are that there is no alternative and there is no catalyst. We do think that cost-push inflation in the U.S. could change this paradigm. Cost-push inflation tends to increase macroeconomic volatility as it adversely affects economic growth in that higher inflation alters consumer behavior by blunting demand and spending, particularly on non-essential goods and services. For example, given today’s lofty auto prices, many households have postponed purchasing a new vehicle.
We think that cost-push inflation is likely to be persistent even after the reopening surge subsides. First, labor supply may not be as readily available as one would think given the high unemployment rate as COVID-19 exacerbated a decline in the labor force participation rate that is unlikely to revert. Second, the sheer amount of fiscal support after COVID-19 will change behavior and tends to raise the structural unemployment rate. Second, after a decade of being penalized by the market for overcapacity, commodity industries are not willing to add significant supply despite higher prices. Environmental, social and governance (ESG) trends also accelerate this.
While the Fed has the tools to adequately deal with demand-push inflation, cost-pull inflation presents a difficulty for them given their new framework and the supremacy of their unemployment goal (returning to pre-pandemic levels) over their inflation goal (ok to exceed target for some time to create an average of 2%). The Fed seems very much behind the curve on the inflation that the economy is currently realizing as well as relative to other Central Banks that have started to taper their balance sheet additions or even raised rates as is the case for many EM central banks. We believe that eventually this policy divergence relative to the rest of the world will lead to a lower U.S. dollar that could take the shine off of U.S. assets (both credit and rates) broadly.
We are instead focusing on global assets that we feel still present attractive total return potential in a world of low yields. For example, we have been adding to the Emerging Market Opportunities Theme that featured a combination of exposures to emerging markets external and local debt. This strategic sector provided the largest positive impact in Q2 as a combination of decreasing yields and underperformance of the U.S. dollar fueled return from this asset class. However, many EM local yields are at the widest yield differential relative to U.S. treasuries that we have seen in two decades despite inflation rates between EM and the U.S. being very close. Similarly, EM external spreads are at their widest level relative to U.S. high yield since 2018.
We also have been adding to our Activist Governments Theme, particularly through Global Inflation Linked bonds. Inflation continues to surprise to the upside and yet for the quarter 5 year/5 year inflation swaps (a measure of the average expected inflation over the five-year period that begins five years from the date data is reported) in the U.S. actually fell by 10 bps. Finally, we have also maintained exposure to our Core Challenges Theme, searching the globe for duration markets that still offer total return potential, but also can be a diversifier for credit in the event of a downturn.
Market-neutral strategies continue to be an important facet of the portfolio. To this end, it added alpha throughout the quarter as volatility continues to present attractive relative value opportunities in rates and currency and especially credit with the Global Credit Absolute Return allocation adding alpha.
Given the decline in yields throughout the second quarter, many market participants have engaged in a debate over “the end of secular stagnation.” We are instead leaning into the view that this cycle may be one where unconstrained, global, and total-return oriented portfolios can truly thrive.
