Portfolio review
Global fixed income sectors generated mixed results over the third quarter of 2021. Sovereign yields drifted higher across many developed markets as major central banks laid the groundwork for policy normalization and started to reduce monetary stimulus at varying speeds. Most fixed income spread sectors outperformed, owing to their income advantage as spreads moderately widened. The U.S. dollar (USD) strengthened versus most currencies.
Central bankers took further steps toward policy normalization during the period in response to mounting inflation pressures. The U.S. Federal Reserve (Fed) indicated it could start to taper its large-scale asset purchases by this November and projected three rate hikes in 2023. The Bank of England (BOE) brought forward its expected first hike to late 2022. Citing improved financing conditions and stronger inflation outlook, the European Central Bank reduced the pace of purchases under its pandemic emergency purchase program. The Norges Bank (Norway) lifted its policy rate to 0.25% from 0% as its economy has recovered from reopening but assured future hikes would be gradual. Select emerging market (EM) central banks further raised rates in response to ongoing inflation and currency depreciation pressures. Meanwhile, the Bank of Japan struck a more patient tone, vowing to maintain policy accommodation, including its negative policy rate, yield curve control, and asset purchases until inflation reaches its 2% target.
Global GDP growth accelerated across most regions during the second quarter, buoyed by continued progress on vaccination and pent-up demand. Ongoing supply chain disruptions and labor shortages indicated inflation pressures may prove less “transitory” than previously suspected. The U.S. labor market continued to heal while house prices rose sharply, supported by low mortgage rates, and record low supply. Chinese manufacturing PMI contracted to the lowest level since the onset of the pandemic, weighed down by rising costs, while services PMI expanded. Eurozone manufacturing PMI remained elevated but fell to a six-month low due to lack of shipping capacity and constrained supply to meet demand. Japan’s current account surplus expanded as exports surged, primarily to China and the U.S., amid growing demand for cars, auto parts, and metals
Global sovereign yields generally moved higher as major central banks reined in policy support while intensifying supply constraints added to inflationary pressures. Major central banks’ rhetoric remained tilted to a bias for the recent inflationary shock to be transitory, while acknowledging that these pressures have persisted longer than initially anticipated.
UK gilt yields increased the most among developed markets after the BOE raised the prospect of rate hikes sooner than markets had expected. Canadian yields ended higher as the Bank of Canada also suggested its initial move to withdraw emergency stimulus would be to raise the policy rate instead of winding down bond holdings. U.S. Treasury yield changes over the quarter were limited. The Fed signaled a start to taper this year with a finish by mid-2022 although the end date was a little more hawkish than the consensus view. Meanwhile in China – despite the worsening cyclical picture – the central bank did not appear eager to loosen policy.
The portfolio realized negative total return contributions from its three components during the third quarter including, strategic sector, market neutral and tactical.
Strategic sector positions generated negative returns for the quarter as the combination of stimulative fiscal and monetary policies, pent-up demand, and supply bottlenecks lifted inflation expectations. This environment benefited positions in global, inflation-linked bonds, cyclical U.S. high yield, and U.S. residential mortgage-backed securities. Offsetting these positive contributions were holdings in emerging markets debt that faced the dual headwind of Fed tapering fears and contagion from the Chinese high yield market.
Looking ahead, Wellington believes the markets have entered a new macro era of higher and more volatile nominal growth and higher and more persistent inflation underpinned by the following:
- A still-early economic cycle: The U.S. economic cycle is still in its very early stages, as shown by the recent high level of new business orders relative to the supply of available inventory. This metric, tracked by the National Association of Purchasing Managers (NAPM), typically rises at the beginning of an economic cycle (the expansion phase), and then falls steadily throughout the remainder of the cycle. This tells us that, like the current cycle itself, inflation too may have legs for the foreseeable future.
- A persistently tighter labor force: The U.S. labor pool looks somewhat constrained and, thanks to demographics, may stay that way for some time. Roughly 5 million U.S. workers have left the labor force since the onset of COVID-19, including around 3 million from the 65+ age bracket that are unlikely to rejoin. And the ratio of prime workers to the total U.S. population is declining, meaning the labor force participation rate should also stay low. This could translate to ongoing labor shortages and upward pressure on wages, which tends to be inflationary.
- Commodities sector behavior: Whereas many commodity producers ramped up their production output sharply during past cycles of rising commodity prices, we are not seeing the same type of response from the commodities sector this time around. Take the oil industry, for instance: As of this writing, Brent crude oil was trading at nearly U.S.$70 per barrel — comparable to its 2018 price range — yet the number of oil rigs was down about 55%. If this trend continues, it may help support higher U.S. inflation more broadly.
- Banks and the velocity of money: So far, U.S. banks as a group have not been deleveraging like they did during the last credit cycle. This could be another inflationary dynamic. In addition, there has historically been a loose correlation between the velocity of money in the U.S. and the relative performance of bank stocks. The velocity of money has been subdued in recent years, but if it were to increase or even just stabilize going forward, this could also contribute to higher U.S. inflation.
- 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 remain at tight levels despite much higher supply, longer duration, and worse credit quality. The Bloomberg Barclays U.S. HY index ended the quarter with a yield hovering between 3.75-4.25%, which in Wellington’s view is inadequate compensation for the volatility of the asset class as exemplified by March 2020. The Fund is short U.S. investment grade credit and has neutralized its HY credit position as well.
The Fund is focusing on global assets that Wellington feels still present attractive total return potential in a world of low yields. The team has been adding to the Emerging Market Opportunities theme that featured a combination of exposures to emerging markets external and local debt. Many EM local yields are at the widest yield differential relative to U.S. treasuries that Wellington has seen in two decades despite inflation between EM and the U.S. being very close.
The team has also been adding to the Activist Governments theme particularly through Global Inflation Linked bonds as inflation continues to surprise to the upside. The Fund has added to its 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.
The Fund has added a new theme within the portfolio titled Sustainable Bond Opportunities that includes both high conviction exposures to issuers the team believes are adapting best to the rapid evolution on environmental, social and governance issues, as well as short positions in issuers Wellington views as ESG laggards that rate poorly on these factors.
Market neutral strategies continue to be an important facet of the portfolio and 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 significant alpha within the tactical component of the portfolio.
Given the decline in yields throughout the second quarter, many market participants are debating the end of secular stagnation. The team is instead leaning into the view and believes that this cycle could be one where unconstrained, global, and total-return oriented portfolios can truly thrive.
