Market Review
Global fixed income sectors cemented their worst ever start to the year following sharply negative returns during the second quarter of 2022. Government bond yields continued to move higher following ongoing monetary policy tightening intentions in response to persistent inflation pressures. Most fixed income spread sectors underperformed government bonds amid increasing concerns that tighter financial conditions resulting from less accommodative policy could tip the global economy into recession. The US dollar (USD) strengthened versus most currencies.
Global GDP growth exhibited some divergence during the first quarter, though most countries continued to expand, with notable contraction in the US and Japan. Inflation pressures remained acute though commodity prices declined sharply late in the quarter to provide some relief. US labor market strength persisted while housing market resilience was tested by surging mortgage rates, lack of inventory, and home price appreciation. Eurozone Manufacturing PMI expanded at its weakest pace in 22 months amid lower demand. Consumer confidence in Germany fell to an all-time low amid concerns about surging food and energy prices as supply chain disruptions persist. Japanese industrial production declined by the most in two years due to weaker vehicle production and continued supply chain disruptions. China’s retail sales slipped as lockdowns associated with the zero-COVID policy drastically reduced consumer spending. UK inflation accelerated to new highs, driven by mounting energy and food prices. Sanctions imposed on Russia by the West led to retaliatory measures from Moscow including restrictions in gas supplies to parts of Europe, raising concerns about Europe’s energy security. By the end of the quarter, global growth had slowed moderately driven by tightening financial conditions, but inflation continued to surprise on the upside and most major central banks became more hawkish.
Global sovereign yields moved sharply higher as most major central banks supercharged their hiking cycles to deal with high inflation. Within the G10, select central banks including the Fed, RBA, and the Riksbankraised rates with surprisingly large moves (50 –75 bps). Even the Swiss National Bank surprised at the June meeting with a 50bps rate increase in a hawkish pivot. This occurred against a backdrop of softening global growth indicators in major economies driven by concerns about energy shortages and the cumulative effect of these rate hikes. Specifically, US 2-and 5-year breakeven inflation rates declined sharply, reflecting concerns that the cumulative effect of Fed rate hikes will be enough to knock the US economy into recession.
The ECB announced its plan to end QE and start hiking rates from July, with President Lagarde suggesting a larger hike would be appropriate in September, if inflation pressures persist. ECB’s announcement at an ad-hoc emergency meeting to accelerate the design of a new anti-fragmentation instrument and apply flexibility to its PEPP reinvestments eased some fears which had contributed to the blowout in peripheral yields. The BOJ and the PBOC were the notable exceptions in terms of retaining accommodative policy. The BOJ doubled down on its yield curve control policy, buying a record amount of Japanese government bonds late in the quarter to cap the 10-year yield at 0.25%. EM central banks particularly across LatAmand CEEMEA also continued lifting their policy rates in bigger increments, while Asian central banks raised rates more modestly than other EM regions. The PBOC maintained accommodative policy as disruptions emanating from mobility restrictions sharply weakened Chinese activity data.
The US dollar ralled strongly versus most currencies as it became increasingly clear that the Fed will likely tighten policy more aggressively to counter persistently high inflation. The yen declined to its weakest level since 1998, as the BOJ remained the outlier among major G10 central banks in not tightening policy. Higher-beta commodity-linked currencies across DM and EM (ZAR, NOK,NZD, BRL) were the other major underperformers as recession concerns came to the forefront by the end of the quarter. LatAmcurrencies, which had held up well in 1Q, also ended lower in 2Q on a combination of rising political risk (COP), global recession concerns (CLP), and fiscal slippage risks driven by inflation-related subsidies (BRL).
Performance Review
During the quarter, the portfolio generated total returns of -7.4% underperforming the Bloomberg Global Aggregate CAD hedged Index which generated -4.35% total return. Given the challenging market backdrop, the portfolio realized negative total returns during the second quarter driven by strategic sector, market neutral and tactical return drivers. Drivers of performance for the second quarter can be summarized as the following:
- Strategic sector positions were the largest negative contributors. The portfolio’s exposure to emerging markets and high quality sovereign bonds came under pressure as markets responded to more aggressive tightening by central banks designed to contain expanding inflation. Credit sectors and inflation-linked bonds also came under pressure as markets began to look through to a potential recession on the back of such a sudden aggressive tightening of policy by central banks globally.
- Although the portfolio realized positive contributions from interest rate strategies, particularly in the US, it was not enough to offset negative contributions from relative currency and credit strategies. The sudden shift tighter in Fed policy led to a significant repricing of the US dollar and widening spreads as investors considered the timing of a potential recession. Consequently, Market neutral currency and credit strategies detracted led by underweights to the US dollar, and relative value positions that featured overweights to emerging markets issuers versus US investment grade corporates. We believe the US dollar has peaked and the current level of emerging markets valuations provide adequate compensation for the risk of recession.
- Tactical strategies negatively contributed over the period, as we were a bit early in removing credit hedges and bank loans spreads widened.
Positioning and Outlook
The yield on the OFI private pool was 6.4% at the end of the second quarter, which represents one of the highest yields for the portfolio in its history. This is representative of the attractive opportunity set available within bond markets after the notable drawdown in fixed income thus far this year. However, while yields on fixed income are the most attractive as they have been for some time, investors should also anticipate that volatility will continue to be quite high over the foreseeable future.
The team broadly divides economic environments into four different quadrants: disinflationary boom, disinflationary bust, inflationary boom and inflationary bust. The last economic cycle was one of the longest ever and fairly consistent in that investors were in a disinflationary boom environment. That cycle favored US equities, US credit and US fixed income. This cycle will likely be much shorter and with much more volatility across the different regimes. From March 2020 to July 2021, the market had been engaged in an inflationary boom environment led by an extremely dovish Fed and too accommodative fiscal policy. This proved a very successful environment for the portfolio as US nominal yields rose along with breakevens, the dollar fell dramatically and credit spreads rallied.
The mistake was not recognizing the significant change by the Fed in their willingness to combat inflation through demand destruction. While the team has maintained very low levels of US duration, the duration that they have owned (EM as well as other smaller, developed markets like New Zealand) has acted with much higher beta than US duration and the short US dollar position suffered from the u-turn in Fed policy. The reason the team has been skeptical about the Fed’s commitment to hawkishness was the high level of asset prices in the US compared to most everywhere else in the world. The team felt this was a constraint on the Fed being too hawkish i.e. if they decided to truly raise real rates into positive territory, financial conditions would tighten dramatically and cause a significant slowdown in growth. The team is seeing that happen today. It is for this reason that they had reduced many of the Fund’s credit allocations last year and the beginning of this year including structured products (13 to 10%), bank loans (9 to 5%) and maintained shorts in HY credit indices at the beginning of the year.
The question is what economic environment investors are in from here: an inflationary or disinflationary bust. An inflationary bust is one whereby high inflation causes a slowdown in growth as real incomes for consumers suffer. A disinflationary bust is one whereby the hawkish Central Bank response to the inflation causes the slowdown in both inflation and growth. The first four months of the year were characterized by an inflationary bust environment whereby credit spreads rose while nominal interest rates and breakevens also rose following the Russian invasion.
Since April, however, the market has increasingly priced the probability of a recession from the Fed hawkishness and credit spreads and the dollar rose, but breakevens and rates have fallen. The team has tried to position the portfolio to be resilient in many of these environments and lean into the environment where the market assigns too high a probability to one outcome or another. If the disinflationary bust environment continues to hold, the team believes the Fund’s Core Challenges theme is set to outperform other core duration markets like the US and Europe. Core Challenges is predicated on the idea that there are better developed bond markets that hedge credit risk compared to the US and Europe. These countries like New Zealand, Australia and Korea have substantially higher consumer debt than the US, which means that their central banks are likely more constrained than the Fed in hiking rates. Despite this fact, the market has priced in a rate structure that is far higher than both the US and Europe e.g. in New Zealand market pricing has the RBNZhiking to 4.5% compared to 3.25% in the US.
In a disinflationary bust, the team believes these markets should outperform the US. They also believe that if true disinflation (as priced by the markets) does take place, then the Fund’s allocation to EM local bonds will also perform well. This quarter the team eliminated the allocation to the Blended Opportunistic EMDpool (half EM external and half EM local), in favor of an unconstrained EM local allocation run by the Fund’s EM Local Portfolio Manager Michael Henry. The drawdown in EM local assets is now the largest ever. Some of the high frequency inflation data points to EM inflation starting to turn the corner and decline from high levels. With policy rates much higher than the developed world there is room for these Central Banks to start cutting rates if disinflation does persist.
If an inflationary bust environment results, which the team believes is most likely, the Fund’s Activist Governments theme should perform well and one they have added to recently. This theme consists predominantly of Developed Market inflation-linked bonds where real yields have risen substantially in the recent quarter. The team believes that the current market-based pricing for inflation-linked bonds is far too low. The market has given the Fed (and other central banks) far too much credibility for their ability to fight inflation. Market-based pricing has US inflation returning to the Fed’s target in 2024, and well below the Fed’s target in 2025 and thereafter. The team believes inflation will be stickier this cycle -labor supply dynamics, lack of commodity investment, worse productivity since COVID, and believe that current real yields are much too high. US 5y5y Real Yields are currently about 85bps, a similar level as they were in 2018; since COVID the long-term real growth outlook has only worsened and the long-term inflation outlook has also worsened.
The Fund’s short dollar position has been a large detractor for the portfolio over the past year, but one that the team believes will prove to be more resilient in an inflationary bust scenario. So far there has been little cost to the Fed by changing its rhetoric i.e. the labor market has stayed tight and the stock market is basically flat over the past 1.5 years. However, monetary policy acts with a lag (particularly in the US where consumers are locked into low-rate mortgages) and the tightening financial conditions are likely to have a significant slowdown on growth in the coming quarters and years. Will the Fed continue to sound hawkish if inflation is coming down, but settling at higher levels, but the unemployment rate is rising and growth rates are plummeting? The team still also believes that the high leverage in the US (debt to GDP at 400%) is a constraint from the Fed hiking rates too much even in the face of sticky inflation. If the markets get a whiff that the Fed could let inflation stay at a higher level than before, the US dollar should underperform.
While the team has talked about the bust scenario, it is worth considering the boom scenarios as well, even though it is far less likely than it was last year. Current market pricing for the Fed has the CB hiking rates to about 3.4% by March 2023 and then gradually cutting interest rates. At the same time, as mentioned, the market has inflation returning to target throughout 2024. If the market is right and all it takes for inflation to get below the Fed’s target is a historically low policy rate of 3.4%, the team cannot imagine anything more bullish for risk assets, particularly with valuations at the most attractive levels they have been since COVID. However, they would caution that this is not an environment where they should expect immediate spread tightening and generic credit allocations will perform well. What created the mean reversion behavior of credit spreads in the last cycle was the aggressive monetary response and fiscal response to any slowdown. They are very unlikely to get either in a high inflation/split government environment and so investors should not expect the same mean reversion behavior. The team believes the credit allocations focused on secured assets (bank loans 5% PMV), credit dislocation (7% PMV) and structured products (10% PMV) are the right allocations to own in a boom environment.
The Fund’s market-neutral allocations have historically served well in high volatile environments. Unfortunately, their performance has been disappointing over the past year as markets have been volatile, but trending. The team still believe market-neutral has an important role to play in the portfolio particularly given the rapidly-evolving nature of the business cycle. Dislocations within credit are astounding with spreads in many sectors like European credit at levels not seen since COVID, at the same time the US investment-grade market have been very resilient to overall weakness given flows from the US pension community. The team believes that these dislocations will converge, setting up these allocations to perform in the coming months and years.
