Portfolio review
Global fixed income sectors were negative over the first quarter of 2021. Sovereign bond yields moved sharply higher following an improving growth outlook and reinforced reflation narrative. Most fixed income spread sectors (i.e. non-governmental fixed income with higher yields at greater risk than governmental investments) continued to outperform as vaccine distribution picked up pace across developed markets and major central banks committed to maintain policy accommodation. Sovereign yield curves generally steepened as easy central bank policies anchored front-end yields while additional U.S. fiscal stimulus lifted inflation expectations. The U.S. dollar (USD) strengthened versus most currencies.
Most developed market central banks reiterated their commitment to look past potentially transitory inflation increases during the economic rebound, against markets' expectations of earlier rate hikes. Some emerging market (EM) central banks raised rates quite aggressively – notably Turkey, Russia, and Brazil – as these countries witnessed higher inflation expectations and currency depreciation pressures. Chinese sovereign bonds represented the lone market to rise in price terms among the 20 largest global debt markets.
During the first quarter, the portfolio realized negative total return contributions from strategic sector and tactical, while market neutral was flat.
Strategic sector positions were the strongest detractors over the quarter given that this is the primary source of duration within the portfolio. The Fund’s Emerging Market Opportunities theme (that featured a combination of exposures to emerging markets external and local debt) provided the largest negative impact. A combination of increasing yields and outperformance of the U.S. dollar fueled a -7.4% total return from this asset class. Positive contributors to performance within this component of the portfolio included holdings in dislocated credit (U.S. high yield) and TALF trickle down themes (structured credit) as the combination of strong economic data and an expectation for larger fiscal and monetary stimulus led to a 0.4% decline in U.S. high yield spreads and 2-3% total return in structured credit markets.
Market neutral strategies were flat for the quarter as the portfolio realized negative contributions from yield curve positions and currency strategies that featured an underweight to the U.S. dollar. This was offset by positive contributions from credit strategies which primarily featured shorts to select credit indices. We continue to believe that as the global cycle continues to improve, and the Fed remains committed to holding a dovish policy stance for the rest of the year, both developed and emerging markets currencies will outperform the U.S. dollar.
Tactical strategies detracted in the aggregate. The portfolio realized positive contributions from corporate versus emerging markets sector rotation positions and long bank loan positions – which was the lone fixed income sector to generate positive total return on the quarter. However, these were not enough to offset tactical long duration and short credit positions held over the quarter. We added to tactical long positions in U.S. Treasuries and short positions in Emerging Markets Debt believing that the significant rise in Treasury yields and tightening of emerging markets spreads had run ahead of the momentum in economic data.
Portfolio positioning
The first quarter of 2021 was the worst performance for the Barclays U.S. Aggregate for at least the last 30 years. According to popular press, the most common reason cited for bonds to have performed so poorly was because of fears of higher inflation. While front-end inflation expectations did rise sharply, if one looks at forward rates of inflation expectations, which takes away the cyclical noise, the 5y5y inflation expectations rose a very modest 12bps. (Note: the 5-year, 5-year Forward Inflation Expectation Rate is a measure of expected inflation – on average – over the five-year period that begins five years in the future). Yet, 5y5y swap rates rose almost 112bps for the quarter so most of the move in forward rates was a result of a real rates (rates adjusted for inflation) moving higher. As noted in the last quarterly update, we felt that nominal growth was set to be much higher this cycle than in the prior cycle. However, the move in real rates was somewhat of a surprise as we thought that most of the increase in nominal yields would be through the inflation expectations channel.
There are several reasons that forward real rates could have moved higher: fears of Fed tapering, bond supply fears or higher future real growth rates are all possibilities. However, we believe the rise was mainly a reflection of a rise in term premia. Term premia can be thought of as the extra compensation one should demand for holding longer-dated bonds in excess of expectations for future short rates and can be correlated with high economic and policy uncertainty. “Uncertain” is an accurate description of the current environment. On the economic side, we do not know how much pent-up demand there is, how much supply damage has been done and therefore how high short-term inflation could be. On the policy side, we have never seen so much fiscal stimulus being injected into an economy in such a short time. Similarly, the Fed’s policy shift last autumn represents a significant departure from monetary policy over the past 40 years. These are unparalleled times and according to the Adrian, Crump, & Moench term premia model, we are at the highest level of term premia since 2016. As bond investors, there are three key questions worth asking. First, what could arrest the rise in term premia in the face of all this uncertainty? Second, assuming you believe that term premia stabilize, what assets should you own? Third, if we are wrong and term premia and real rates keep rising, how do we protect a bond portfolio? Global savings glut – For the past 20 years, consumption has been suppressed. First, current account surplus countries were trying to grow their manufacturing capabilities. Then, after the GFC, consumers globally focused on balance sheet repair. The COVID-19 crisis changed both conditions. The largest current account surplus countries are now focused on rebalancing their economies toward domestic consumption. Housing markets are also thriving, which has the potential to give consumers the confidence to draw down savings now that balance sheets are repaired.
What can arrest the rise in term premia?
Much of the anxiety in the market relates to how the economy will look when we fully reopen. In particular, supply bottlenecks could emerge, putting pressure on short-term inflation. The market fear is that the Fed might need to accelerate its hiking plans as a result. We do not feel that this is particularly likely. One of the reasons we are seeing prices rise in the short-term is because producers are dealing with the same questions with which we wrestle. Normally, price increases are a clue to producers to increase their capacity. However, if you are the maker of some product that has seen substantial demand because of COVID-19 (e.g., online shopping, gym equipment), you are unlikely to increase your production right now. Instead, you will want to see what the true demand for your product is in a reopened economy. If after this, you still see price increases, you might then be willing to increase capacity, which should eventually lower prices. The Fed, after missing on its inflation goals for much of the last cycle, has already said that a temporary rise in core inflation is not worrying to them and only persistent rises in inflation would give them cause for concern. We anticipate that the Fed could start discussing tapering their balance sheet this summer for eventual liftoff early next year. But the impetus for this would be the strong economy rather than a temporary rise in inflation (that will not alter a defined pre-set course for the Central Bank). There is also the risk that the economy might open slower than many currently estimate, as policy responses lag consumer behavior.
Finally, there is the fear that fiscal policy will continue to run amok. In our view, the era of Central Bank independence is over and that fiscal-monetary coordination is the new regime. After the Democrats secured the Senate, a $1.9 trillion COVID relief bill was passed with ease. President Biden released a $2.25 trillion infrastructure plan and is planning on similarly sized human infrastructure bill in the fall, paid for with higher taxes. However, once again, while fiscal policy uncertainty is high right now, we believe this may dissipate somewhat over the next few months. While the economy is closed, it is very easy to pass bill after bill of stimulus. When the economy opens, it might be much more difficult for moderate Senators to support drastic spending when the job picture is looking promising and the economy is soaring.
What if term premia stabilize or fall?
We believe the rise in term premia has made forward real yields attractive. 5y5y real yields are currently trading at about 32bps, which is at similar levels with which we started 2020. This cycle could be met by higher forward inflation expectations and we have yet to see fiscal spending that has the potential to meaningfully raise real structural growth. Nominal growth can be artificially inflated by fiscal spending geared towards consumption, but that does very little to raise actual productivity. As such, we have been adding to forward real yields within the portfolio. The rise in term premia is not unique to the U.S., however. We have been adding to the Core Challenges theme, finding global bond markets like Thailand and Singapore, which have seen similar rises in yield as in the U.S. and are still suffering from very low levels of inflation.
Similarly, we have been adding to the EM opportunities theme as we believe that EM local bonds and FX could be the biggest beneficiaries of a stabilization in U.S. term premia. EM assets performed poorly in Q1 2021. While the fundamental situation in EM countries is much better than it was prior to the 2013 taper tantrum (smaller current account deficits, cheaper exchange rate, lower inflation), market participants still remember how poorly the asset class did during that time period and are injecting substantial risk premium into a number of EM local bond markets like Mexico as a result.
What if term premia keep marching higher?
We are cognizant that, relative to long-term history, term premia are still low and therefore could continue to rise higher. If they do, however, we do not think that U.S. credit will be as resilient to a rise in real rates as it has been to date. While the stock market is going through a meaningful rotation from defensives to cyclicals and from growth to value, much of the market cap of the index is still in tech and healthcare, two sectors that depend on lower real rates to maintain their lofty valuations. If real rates continue to rise, it is likely that these long duration assets could suffer, which could hurt U.S. stocks broadly. We have lowered the credit beta of the portfolio by shorting high yield bonds trading at all-time low yields of 4%.
Similarly, while we expect the Fed to stay on a present course and ignore short-term inflation, we acknowledge the potential for risk assets to stay strong at the same time the economy could be weak. The Fed may feel compelled to take some steam out of asset prices and position for an earlier and more aggressive tapering. We have been shorting 5y real yields as a portfolio hedge in the event of more aggressive Fed action and government bond markets like the UK and Europe where term premia have not risen as extensively.
Finally, if we are wrong, and fiscal policy continues to be substantial and consumption-driven, ultimately, we anticipate that this profligacy could be met with a lower U.S. dollar. The dollar performed relatively well in the first quarter with the Bloomberg dollar index rising 3.4%. Dollar performance is one of the reasons we ascribe the rise in yields as mainly being due to term premia rather than bond supply fears, as the latter should produce a weaker dollar.
While we anticipate potential falling term premia over the next few months, as always, the Fund maintains diversification within its strategic themes, many of which are uncorrelated with term premia, as well as across market-neutral and tactical positions. As a broad observation, markets are facing a very challenging macro environment that we haven’t experienced in a long time, certainly post-global financial crisis (GFC). This may be because of a confluence of factors:
- markets haven’t seen this combination of fiscal expansion/high nominal growth and inflation expectations;
- unprecedented actions of support from policy makers; and
- certain sectors of the market (electric cars, SPACs, Bitcoin, etc.) experiencing extreme valuations and markets struggling to price assets with no valuation anchor.
One way these trends are manifesting is the increasing amount of dispersion across all markets: credit, rates, currencies, and subsectors in equities. It is a challenging environment, but also one that presents significant alpha opportunities for our dynamic rotational strategies.
Fund performance
