Market Review
Global fixed income sectors experienced one of their worst drawdowns ever during the first quarter of 2022 as government bond yields rose sharply following more aggressive monetary policy tightening intentions in response to persistent inflation pressures. Most fixed income spread sectors underperformed government bonds amid the expected slowdown in economic activity brought on by tighter financial conditions, exacerbated by uncertainty arising from the Russian invasion of Ukraine, though spreads recouped a portion of their widening late in the period. The US dollar (USD) ended mixed.
Global sovereign yields moved sharply higher led by short-end yields. Even as global growth expectations were downgraded, major central banks pursued more hawkish policy stances given their views that a significant chunk of the recent inflation acceleration will likely persist as a result of the energy supply shocks and rising inflation expectations. The market continued to rapidly reprice Fed hike expectations and the FOMC signaled willingness to step up the pace of hiking if it continues to fall further behind the inflation curve.
Given rising geopolitical tensions and the aggressive sanctions imposed on Russia, emerging markets experienced the most intense level of volatility in the wake of the Russian invasion of Ukraine. However, the combination of persistent inflation pressures and tightening central bank policy has also led to a broad fixed income market sell off as both credit spreads and interest rates have moved higher on the fear of rising inflation with investment grade corporates and high yield generating -5% to -10% total returns year-to-date.
Performance Review
During the quarter, the portfolio generated total returns of -7.5% underperforming the Bloomberg Global Aggregate CAD hedged Index which generated -5.0% total return. The portfolio realized negative total return contributions from its three components during the first quarter including, strategic sector (-4.1%), market neutral (-1.1%) and tactical (-1.4%) bringing total return for Q1 2022 to -6.6% (USD).
Pre-invasion
At the start of the quarter, the team positioned the portfolio believing that US growth was poised to slow down considerably as consumers retrenched due to high prices and that inflation was likely to shift from transitory (as supply chains repaired) to structural (on higher wages). The team expected cyclical leadership to transition away from the US, anticipating that the European cycle would be extremely strong driven by a drawdown in consumer savings and a normalization of their/China’s economy throughout 2022. The team further expected that market liquidity would be quite good throughout 2022, believing that the combination of continued QE through March as well as strong bank lending in the US should mean that the liquidity fears that the market was focusing on in January would eventually subside.
Based on this outlook, prior to the invasion the team made a number of portfolio adjustments.
- First, they built liquidity in the portfolio by reducing the Structured Product and Bank Loan allocations while maintaining beta by reducing some of the HY derivative shorts.
- Second, the team added US duration at the front-end of the curve as they believed the market was not pricing in a deteriorating growth picture in the US.
- And third, they maintained shorts in European duration on an improving outlook for the continent with growth stronger than in early 2018.
- Lastly, they added to shorts in a number of high yielding frontier Emerging Markets external debt issuers with the view that this cohort of issuers would underperform in the event of a stronger than expected escalation by Russia. The resulting portfolio held duration of approximately 6 years, significant positions in sovereign governments and was short several credit sectors.
Post-February
As volatility unfolded at the end of February, the Fund’s holdings in high quality developed government bonds (nominal and inflation linked) benefited briefly from the risk aversion that led to a flight to quality across markets; however, as oil and other commodity markets surged interest rates rose further and the highest quality fixed income sectors underperformed sharply. This market environment created challenges for each component of the portfolio with long-term strategic sector, market neutral and tactical positions each delivering negative performance year-to-date. And on a sector basis the largest detractors included emerging markets debt and IG corporate.
- Strategic sector
- As markets moved to price in the consequences of sanctions on Russia and Ukrainian debt, almost all fixed income sectors generated negative total returns. Consequently, the strategic sector positions, given their long market orientation, was the largest detractor to the portfolio’s total return. In particular, Emerging Markets Opportunities strategic sector holdings detracted the most with Russian exposures contributing -2.9% negative total return over the year-to-date period.
- Emerging Market Opportunities has been an important theme in Opportunistic Fixed Income. The thesis has been that emerging market countries experienced a perfect storm over the past five years, marked by trade wars and tariffs emanating from Washington DC and of course the global pandemic that stressed financing needs. Yet through this challenging period most EM central banks conducted monetary policy in a very orthodox and proactive manner, with the average EM central bank raising rates by 150bps. Russia local debt exposure was a part of the Emerging Market Opportunities theme, as the country had been showing positive debt dynamics and expected to return to budget surplus this year, and there were signs the Central Bank of Russia was nearing the end of its tightening cycle. However, the team did not anticipate that Russia would launch a full-scale invasion of Ukraine and as a result these positions contributed negatively to portfolio performance.
- Market Neutral
- The market neutral strategies also suffered as risk aversion swept across broad global fixed income markets resulting in negative contributions from currency and credit relative value strategies. Within currencies, the team preferred select emerging local currencies versus the US dollar which underperformed during this period of risk aversion. Within credit relative value, long positions in emerging markets issuers versus shorts in US high yield corporates detracted.
- Tactical
- Finally, within tactical, while the team realized positive contributions from long duration positions in several developed markets including European peripherals, as well as short positions in US IG/high yield credit, it was not enough to offset negative contributions from long positions in select developed market IG corporates and Eastern European sovereign issuers.
Fund positioning
The Russian invasion is likely to exacerbate the key trends of slowing growth and higher inflation. The growth outlook in the US looks particularly worrisome, and markets are starting to sniff this out with the yield curve the most inverted in forward terms since the early 1980s. US consumers are pessimistic about the future. The root cause of this negativity is inflation with most consumers believing that now is a bad time for new purchases.
While the team has added to overall duration, the Fund remains significantly underweight US duration as well as European duration; the other core duration markets within global fixed income. The reason for this lack of enthusiasm for core duration is that the team thinks that inflation, particularly in the US, is likely to be stickier than people think, and the Russian invasion will only exacerbate this. The team has been adding to duration but predominantly outside of the core markets. From the team’s perspective, an attractive duration market is one that has:
- High levels of consumer/household debt, which will prevent the Central Bank from getting too hawkish even with an inflation surprise
- A floating rate mortgage market as hiking rates get passed through quickly to the consumer
- Less historic QE and a small Central Bank balance sheet so there is room for the Central Bank to get aggressive in a downturn
- Strong currency with a commodity currency being a positive as there is less risk to the long-term inflation outlook, even if growth will be strong in the short-term
This framework has led the team to countries like Australia, New Zealand, Norway, Canada, Korea and Israel. All these countries remain some of the Fund’s largest positions within both Core Challenges (14.8%) as well as Activist government themes (17%).
The Fund held Russia local debt exposure as part of the Emerging Market Opportunities theme. At this point, the holdings in Russia local debt have been marked down to $3 and the total exposure to Russia in the portfolio is only 0.1%. The team would like to exit the positions in a manner that maximizes value, but as of now foreign holders cannot sell their bonds on the local exchanges where they are trading $70-$80. The situation is constantly evolving, and the team will update you if the local exchanges open.
While the Fund’s Russian exposure was certainly a disappointment for the EM Opportunities theme, EM local debt/opportunities remains one of the highest conviction views (24%). The Russian invasion is certainly a setback for the immediate decline in inflation the team was expecting for EM countries. However, EM countries are in a much better position to deal with this inflation than the Developed World with many countries close to having positive real rates while still having substantial output gaps and high unemployment rates. The team believes that if inflation can make a turn lower, EM local rate markets might be the largest beneficiaries aided by currencies that are carrying very well relative to the developed world and are very cheap in real exchange rate terms.
The direct credit exposure within OFI is on the lower end historically as the team has trimmed some of positions in Structured Products (10%) and Bank Loans (6%) while maintaining the Credit Dislocation Strategies theme (8%). They believe it is probably too soon to get very bearish on credit spreads.
Takeaway
The team was disappointed with the returns of the portfolio in the first quarter. From a high-level, the reaction in Russian assets has made the team reconsider their approach to ESG among sovereign nations. While the exposure to Russia was consistent with other EM holdings historically, clearly the ESG story had been deteriorating for Russia well before the most recent invasion of Ukraine. The team eliminated the holdings of Chinese government bonds within the Core Challenges theme for reasons based on valuations and ESG risks related to deteriorating US/China relations. Such considerations will be extremely important going forward and will broadly affect the Fund’s individual country exposures in the portfolio.
