Market Review
Global fixed income sectors added to the malaise of 2022 following sharply negative returns during the third quarter. Concerns about persistent inflation and ongoing global monetary policy tightening contributed to escalating volatility, leading to official sector interventions in U.K. and Japan. Excess returns over duration-equivalent government bonds varied across sectors driven by elevated global recession risks and disruptions to Europe’s energy supply. The U.S. dollar strengthened versus most currencies.
Global growth indicators displayed some resilience during the second quarter, even as recession risks mounted. U.S. GDP contracted for a second consecutive quarter, though officials stopped short of declaring a recession given the strength of the labor market and industrial production. Inflation data offered scant evidence of easing price pressures, with particularly high prints across the UK, eurozone, and US. A notable exception was in China, where moderate inflation has enabled the central bank to pursue much easier policy than other global central banks. While US labor market strength persisted, housing started to show some cracks following the sharp move higher in mortgage rates and a notable record slowing of home price appreciation. Eurozone manufacturing and services PMls each contracted, dragged lower by higher costs, weaker demand, and increasing economic uncertainty. Japanese retail sales and household spending exceeded estimates despite a resurgence in COVID-19 cases. China's economic data faltered over its zero COVID policy and ongoing property market slump, though official PMls remained slightly in expansionary territory by the end of the period as supply chain bottlenecks eased. UK consumer confidence plunged to a record low amid the country's historic cost of living squeeze.
Performance Review
During the quarter, the portfolio generated total return of -3.2%, outperforming the Bloomberg Global Aggregate CAD Hedged Index which generated -3.56% total return.
The team believes that the most attractive relative value opportunities tend to surface in more volatile environments, and the third quarter was no exception. They were encouraged by the returns for the portfolio in Q3, as the Fund’s flexible portfolio structure with diversifying allocations to market neutral strategies proved beneficial. The component of the portfolio is designed to have a low correlation to traditional fixed income risk factors like duration or credit, and thus can add alpha in fixed bear markets. While the Fund’s overall strategic sector positioning detracted during the quarter, several of the key longer-term themes are beginning to be appreciated by the market. The EM Opportunities theme added value, a reflection of the idiosyncratic nature of EM local debt markets and recognition that EM central banks got well ahead of DM central banks in reacting to upside inflation surprises. Meanwhile. the holdings within Activist Governments and Core Challenges were able to outperform virtually every other fixed income sector, as the team was able to take advantage of greater dispersion and falling correlations across G10 countries.
The Fund was more resilient than most fixed income sectors during the quarter generating excess return when compared to the Bloomberg Aggregate CAD Hedged reference benchmark. Key drivers were an emphasis on non-US sovereign markets, short positions in select credit and emerging markets, as well as dynamic positioning between and across global interest rate markets.
- The largest contributor to portfolio management were positions in emerging markets debt. The team believes that market pricing was not reflecting the aggressive action many emerging market central banks had taken in getting ahead of inflation and the potential for these countries to move to an easing bias in the coming months. The team believes that investors have began to acknowledge this in the third quarter.
- Broad credit positioning was also a positive contributor during the period as both sector and security selection strategies contributed. The team held positions in the strongest performing credit sectors and industries during the quarter including bank loans, energy sectors and U.S. mortgage-backed securities. Collectively these positions generated positive performance over the period.
- Although the portfolio realized positive contributions from interest rate strategies, the decision to hold much of the duration outside of nominal U.S. Treasuries benefited the portfolio. The team’s preference to hold non-US inflation linked bonds and nominal bonds in Australia and Canada provided significant downside protection relative to U.S. interest rates, but 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 U.S. dollar and widening spreads as investors considered the timing of a potential recession.
Positioning and outlook
Forward-looking returns have rarely been so attractive for fixed income, and this is well reflected in the portfolio yield of 6.02% as of September 30 2022. However, while overall bond valuations look attractive, the team expects to see higher and more volatile inflation and economies will spend more time oscillating through cycles rather than in a steady state, similar to what was experienced in the mid-1960s through the 1980s. The need for dynamic fixed income sector management has never been more important. Recognizing this, the team has added three new themes to the portfolio to capture this regime change:
- Short Cycle Credit – The team expects the business cycle to be much more evenly distributed across growth and inflation regions compared to the last 27 years of a goldilocks disinflationary, growth environment. Most investors are overallocated to credit assets that benefit from the disinflationary boom environment namely U.S. Investment Grade Credit and BB-rated High Yield bonds. The team seeks to have credit exposure that diversified and is dynamic across environments and allocate to managers at Wellington who have experience navigating various economic cycles. Security selection expertise is increasingly important to take advantage of this increased dispersion.
- Term Premia normalization – the demand/supply balance for global safe assets is moving towards a deficit of $1 trillion in 2023 compared to a surplus of $2 trillion in 2021. Historically, this metric has been inversely correlated with term premium. The eurozone is the centre of this seismic shift and is incredibly important given it has the largest savings and current account surplus in the world combined with an aggressive QE program. Central banks maybe trying to contain inflation, but politicians are undermining them through fiscal responses skewed to transfers not allowing for the demand adjustment required. The team believes global yield curves are exceptionally flat and markets underestimate the normalization potential for term premia.
- Stranded Credit – Many convertible bonds, particularly in the tech sector, were issued at rich valuations last year. As growth stocks have sold off, these bonds have declined substantially in price and many of these busted convertibles are trading close to their bond floor. Similarly, many capital securities have sold off this year due to the rates and credit sell-off. While historically these bonds were priced to their first call date, the market is currently pricing these bonds to worst/maturity. Both of these sectors of fixed income or orphaned from traditional High Yield and Investment Grade ond investors, but the team finds these securities to have low price downside and strong positive convexity.
The portfolio themes are well diversified across the different regimes. However, although the Fund’s exposures are well diversified, it is certainly leaning into the various market opportunities that present themselves.
- Within the activist government theme, the team continues to believe that inflation expectations are broadly mispriced and are looking to increase exposure to the front-end of the US TIPs curve with 5y real yields close to 2%. While the team underestimated the Federal Reserve's focus on bringing inflation down at the cost of growth, they believe that potential growth has fallen post-COVID consistent with an environment of weak productivity and sticky inflation.
- At the same time, the team has been adding to the core challenges theme focused on duration markets characterized by positive current account surpluses, low government debt to GDP, high consumer debt to GDP and a fiscally conservative government. The experience in the UK government bond markets throughout September illustrates how important country selection is even in government bond markets. Finally, the team is increasing their tactical duration through adding current coupon agency mortgages. They believe that the inflation markets are mispriced with 5y5y inflation swaps currently at only 2.15%. However, if the market is correct about the long-term prospects for inflation, then Agency mortgages have not been as attractive since 2008 when many thought Fannie Mae and Freddie Mac were going to default. The portfolio duration of the Fund is 6.1 years, and when combined with a 6.0% yield, they represents the substantial potential the team sees in fixed income delivering strong risk-adjusted returns going forward.
In addition, there are many lessons learned from the first half of the year that the team has incorporated into the portfolio going forward that will hopefully increase portfolio's resiliency in a volatile market as well as enable the Fund to generate the strong total returns that investors require from an approach like Opportunistic Fixed Income.
- The first lesson pertains to the market-neutral allocations. In the first half of the year, the momentum factor dominated in rates and credit market leading to the underperformance in the absolute return strategies that employ mean reversion strategies. In addition, FX volatility has been trending higher as central banks move away from forward guidance and fiscal policy plays a larger role in country relative growth expectations. As a result of these themes, the team has increased the weight of Government Relative Value a momentum-based long/short rates strategy. In addition, they have eliminated the allocation to Absolute Return Bond and Currency and reduced allocation to Opportunistic Currency. As a result of these changes the portfolio's total contribution to risk from foreign exchange has decreased and is close to the lows of the Fund’s long-term average
- Within Strategic Sectors, there have also been several important learnings. First, while the team does believe this is a historic opportunity to add to EM local debt with many central banks nearing the end of their hiking cycles, the idiosyncratic risk in the asset class on a countryby-country basis is substantial. As a result, they have been reducing the Fund’s country allocations to EM local, but maintaining overall exposure by adding a new allocation. This allocation is a custom solution called EM Unconstrained Local with a benchmark of GBI-EM ex China. The team’s choice to exclude China from the benchmark reflects the renewed importance of geopolitics in structural allocations.
