During the third quarter (Q3) of 2023, Sun Life Wellington Opportunistic Fixed Income Private Pool series F (the “Fund”) generated -2.33% and underperformed the benchmark’s (Bloomberg Barclays Global Aggregate Bond Index - C$ Hedged) return of -1.95%. For Q3, the strategic and tactical sectors detracted performance while the market neutral sector contributed to performance.
Within the strategic component, emerging market (EM) local bonds were the main detractor for Q3. A sharp rise in U.S. yields since July hit the performance of EM lobal bonds. Our sub-advisor Wellington Management Canada (Wellington) used the weakness in EM local bonds to add to the asset class in August. Despite the Q3 drawdown in the asset class, EM local bonds has been the largest contributor to returns over the past year and the sub-advisor has high conviction towards this allocation.
Allocation to developed market (DM) inflation-linked bonds and non-U.S. sovereigns also detracted performance in Q3. The rise in U.S. yields hit the portfolio’s longer duration positions.
The portfolio’s exposure to short term cyclical credit contributed to performance as credit spreads remained resilient.
Market neutral component was a mild positive contributor for Q3. The sub-advisor generated positive returns in Q3 by taking advantage of currency volatility. Short positions in DM currencies that are dependent on commodity exports also helped performance.
Within tactical component, the mortgage-backed securities (MBS) from quasi-governmental U.S. agencies detracted performance. The sell-off induced by the jump in U.S. yields hurt performance. The sub-advisor holds higher coupon mortgages that are currently trading at spreads similar to levels in March 2020 and not too far from the levels last seen in the GFC. The agency MBS asset class has suffered because of a lack of support from the banks, historically one of the largest buyers of the asset class.
While Wellington does not expect the banks to buy agency MBS in the short term, the sub-advisor may allocate a portion of its considerable cash to the asset class. This may happen if the U.S. Federal Reserve (the Fed) cuts interest rates or that adding agency MBS would not extend the duration in the sub-advisor’s portfolio.
Positioning and outlook
As noted in our sub-advisor’s past two quarterly updates, the portfolio is characterized by high levels of duration and low levels of credit risk. Wellington predicts inflation could fall further than what both the Fed and the market anticipate currently. Wellington also believes credit spreads are too tight given the weakness in the business cycle.
The sub-advisor feels inflation has continued to surprise to the downside and that core Consumer Price Index (CPI) excluding shelter costs is only 2.2%. Wellington also expects shelter inflation to turn lower as well. The Fed’s preferred measure of inflation, core PCE, is running at 2.14% on a three-month annualized basis, not far from the Fed’s stated goal of 2% inflation. While Wellington’s inflation call has been correct, U.S. yields have continued to march higher as the market’s base case has shifted from a soft landing to no landing.
Wellington’s views on immediate economic outlook has yet to play out. The sub-advisor expected deterioration of liquidity in the U.S. debt market and weak corporate profits for U.S. companies. But both have remained resilient and kept credit spreads relatively benign. However, the sub-advisor expects cyclical risks to rise and profit outlook to turn sour. It expects higher risk as:
- The possibility of a U.S. Government shutdown rises over the next few months and fiscal spending wanes.
- Excess savings depletes for lower income consumers
- Federal student loan payments resume in November
- Strikes by U.S. autoworkers threaten output
The U.S. dollar appreciated in Q3 and this has hurt the portfolio’s underweight position in U.S. dollar.
Wellington increased its underweight position to the USD in Q3 even as the currency continued to rise despite overall weak inflation and employment data.
The sub-advisor feels USD and U.S. fixed income are not the bastions of safety they once were. This has created an asset allocation challenge at a time of decelerating growth and elevated equity valuations. This is the main reason why Wellington is focused on DM countries with low levels of government debt, high levels of consumer debt and a prevalence of variable-rate mortgage markets. High mortgage rates could mean that Canada, Norway, Australia, New Zealand, and Sweden, among others, experience economic pain sooner than the U.S.
On the currency side, the sub-advisor believes that EM currencies could be more resilient despite their historic underperformance in slow growth and risk-off environments. Interest rates remain at double-digits in many EM countries even as EM inflation has fallen below that DM economies. Many EM asset classes now offer higher yields than that offered by risky U.S. asset classes. This is one of the reasons the sub-advisor added to EM opportunities in August.
The sub-advisor expects global real yields (inflation-adjusted yields) to trend lower next year. Wellington does not agree with market’s expectations that real interest rates across the world would be higher than that witnessed in the past 15 years. Most of the spending since the pandemic has gone to either consumption or residential investment, neither of which raise forward-looking expectations for productivity. In fact, one could make the opposite case that spending today means lower future consumption. Global population growth has also slowed substantially meaning that structural growth rates should be much lower than they were before the pandemic. Despite these headwinds, real yields globally are at their highest level since 2007. Adjusted for liquidity, real yields are also at their cheapest levels since inflation-linked bond asset class was first created in the late 1990s.