The terrible tragedy in Ukraine has been difficult for us all to watch, and we can only hope a swift resolution is found.
Well before the escalation of the crisis we argued that a natural deceleration in durable goods spending, fading fiscal and monetary support and reduced purchasing power given high inflation were all factors pushing towards a potential macroeconomic slowdown, which would likely lead to a dovish pivot from central banks.
What has changed?
Persistently higher prices resulting from the war – not just in energy but also in agricultural and industrial commodities – are going to have a very damaging effect on global growth, bringing forward the slowdown. We believe recession is now almost certain in Europe, and very probable in the US on a longer-term view.
Three key inputs to US growth are now under attack: gasoline prices are already causing demand to slacken. The rise in yields has caused mortgage rates to rise sharply. The equity market has sold off. Combine that with slower growth out of China and the impact of comfortably over 100 rate hikes globally since February last year, and the global economic outlook has worsened significantly.
Who wants to be a central banker?
Higher inflation and lower growth make life immeasurably more difficult for the US Federal Reserve (Fed). The pressure to hike rates will be more prolonged, even as growth slows more sharply. The Fed will find itself increasingly trapped between the devil of inflation and the deep blue sea of recession.
The risk of a policy error is extremely high. The Fed started its rate hiking cycle at the 16th of March meeting, and its own forecasts suggest six more hikes this year, and more in 2023. Studying the yield curve, we believe the Fed will struggle to implement anywhere near this many rate hikes. What is even more problematic is that we think the Fed is tightening policy into a slowdown, which will be very challenging for risk assets.
In the shorter term, we see the yield curve continuing to flatten and eventually inverting (as short-term rates are pushed higher but long-term rates are anchored by lower growth). In the longer run, we believe excessive tightening will deepen and prolong the slowdown, and force a more drastic policy response further down the line, leading to much lower yields. Parts of the US Treasury curve have already inverted: the 7-year Treasury is now yielding more than the 10-year and the 5-year is now on the brink of also yielding more than the 10-year. Typically, if this inversion is maintained for a few weeks the rest of the curve follows through and the probability of a recession in the next 12 to 18 months rises materially.
Duration: staying long
We think it makes sense to remain long duration here: we made a material cut in duration at the end of last year to protect against a hawkish Fed. We added most of that duration back in January and February as yields rose.
Why stay relatively long duration when the Fed is likely to keep tightening? Our macro view and positioning is long term: we have very high conviction that a significant growth slowdown and the eventual fading of inflation will cause another material leg down in government bond yields as central banks have to change course. The move lower in yields is likely to begin with the long end so in recent months we have shifted some exposure longer. From a structural standpoint, we believe that high-quality government bonds and duration can still act as a diversifier, especially in the context of sudden and sharp growth shocks.
Credit: slowly getting bullish
We came into the year expecting central banks to cause some risk asset volatility and sought protection with a bias to short-term paper in conservative sectors, with a focus on special situations. That volatility has played out – perhaps even more than we expected.
High-yield valuations sit at levels we have only seen rarely in the past decade, and every time they have reached these levels, we have tended to see a sharp bounce back. Specifically, BB-rated credit in Europe stands out as the most attractive part of the market for us, with spreads only spending 11% of the last decade at cheaper levels. We have been putting some of that dry powder to work; for credit investors it is pretty exciting to find, for example, BB paper in solid European names in conservative sectors such as telecommunications trading at over 6% in yield with relatively low cash prices.
At the same time, the risks of worse economic news mean we can see more volatility ahead, so it seems prudent to keep some of that powder dry. The higher volatility in yields and inflation make this a great time for active investors who can differentiate in what they really want to own.
Conclusion: volatility opportunity
The first few months of 2022 have been very tough for investors of all stripes: there has been almost nowhere to hide. Volatility always breeds opportunity for active investors, and we are more bullish for fixed income and our portfolio than we have been in some time.
With a growth shock on the horizon, central banks will have no choice but to accept another lurch down in yields as recession surpasses inflation as the major economic problem. We expect over the medium term that government bonds can be a major contributor.
Credit has sold off across the board this year, and valuations are now attractive to us on any medium-term historical measure. We believe it is sensible to lock in attractive yields in higher quality bonds and expect to find more over the next few months as volatility continues. These opportunities in fixed income only come round once every few years, and we think investors should be positioned to profit.
The value of active minds: independent thinking
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