A few years ago, we explained how an extremely low-rate environment was causing us to adjust how we manage our portfolios. That environment, created by central bank intervention in the wake of the great financial crisis of 2008 and the subsequent European debt crisis, reset the rules of fixed income management and led us to incorporate even more components of economic and financial theory into our portfolio management.
2020: A delayed normalisation
For years, we had anticipated a normalisation of bond markets, but in March 2020, they were once again “saved” by an event – the Covid-19 pandemic, which required intervention by monetary authorities.
In reaction to the uncertainty created by this global pandemic on a scale never seen since the Spanish flu of 1918, most of the world’s central banks once again undertook to support financial assets, from euro zone sovereign debt to US corporate bonds.
As a result, and facing a looming market crash of historic proportions (the S&P 500 lost 34% in less than one month between 19 February and 23 March 2020, and the 10-year US reference yield spiked in the first days of March after initially falling), the European Central Bank (ECB) and the US Federal Reserve (Fed), in particular, ended up intervening massively. Their measures included the ECB’s Pandemic Emergency Purchase Programme (PEPP) and the Federal Reserve’s Main Street Lending Program (MSLP), which targeted small and mid-sized US companies.
All financial assets rallied on these new quantitative easing measures.
2021-2022: the inevitable return of inflation
Even so, new signs of inflation, which was already smouldering in 2018, came back to the fore (the pressures seen then had led to an initial monetary tightening before receding once again during the pandemic). This resurgence in inflation was fed not only by the supply-side shock, which stood accused by all economies but also, and mostly, by the exceptionally accommodative policies of central banks, as well as many countries’ fiscal spending programmes.
US inflation (consumer price index)
Source: Bloomberg
As a result, all the ingredients necessary for a return of inflation were there:
1. Lockdowns and a zero-Covid policy still being enforced in China in 2022 greatly disrupted production capacities and supply chains, generating a heavy supply-side shock. By nature, a supply-side shock raises prices and lowers output in the short term.
2. The acceleration in the money supply, the inflationary impact of which was formalised in the quantity theory of money and the work of Milton Friedman [1].
Federal Reserve balance sheet in millions of dollars
Source: Bloomberg
M2 money supply in the US (in billion USD)
Source: Bloomberg
3. Heavier fiscal spending: the pandemic convinced even the most ardent supporters of fiscal orthodoxy of the need for public spending to maintain economic activity as much possible. Fiscal outlays soared by an unheard-of degree in the US, Europe and many other countries. Such spending ratcheted up the debt burdens of the countries concerned, which, in turn, worsened their solvency just as the economy was contracting.
Estimated fiscal support of selected countries during the pandemic (deviation from observed budget)
Source: François de Soyres, Ana Maria Santacreu and Henry Young, “Fiscal policy and excess inflation during Covid-19: a cross-country view”, Federal Reserve [2] – 15 July 2022
4. The war in Ukraine was an additional inflationary factor that exacerbated the supply-side shock in certain raw materials, such as fertilisers, grain, oils and, indirectly, oil, coal and natural gas.
5. The job market is also driving inflationary pressures. For some time, the relationship between inflation and unemployment had been called into question [3]. It is now undeniable that the robust job market is another reason for the resilience of inflationary pressures.
Fed funds target rate (the main US key rate)
Source: Bloomberg
Volatile markets
Amidst volatile markets offering no respite to investors, against a backdrop of unprecedented interventions by monetary and governmental authorities, and amidst a public-health crisis, followed by a geopolitical one (the war in Ukraine), identifying strong convictions to construct our portfolios was more essential than ever. At a time when indices’ modified durations (sensitivities) were at a high, we had already stressed the pointlessness of benchmarking for asset managers taking care not to give into bandwagoning (by which we mean blind devotion to the characteristics displayed by bond markets and their related indices). Technical criteria alone (such as assessing momentum or rate fluctuations around their moving averages) is no longer any way to manage bond portfolios rationally.
10-year German and US reference yields
Source: Bloomberg
The environment has recently change radically, particularly in the wake of inflationary pressures and the shift in tone by central banks. We remain confident that an active and selective approach, freed from any benchmarking constraints, is the best way to take on the bond markets.
That’s why more attention has to be paid to credit research, which can discriminate clearly between issuers based on their credit quality and their intrinsic features. Such an approach requires taking some distance from indexing and crossing some lines, particularly regarding market segments. For bond investors, it is more necessary than ever to diversify between investment grade and high yield, between sovereigns and corporates, between developed and emerging markets, and between subordinated and non-subordinated, rather than hunkering down on individual markets. Such an approach allows bond managers to better exploit the heterogeneity that characterises these different market segments.
Those market segments that are absorbing the shock
In the past 36, 24 and 12 months, most (if not all) asset classes have shown positive correlations (or none at all in best cases): S&P 500 equities, high yield bonds, investment grade corporate bonds, emerging market bonds, European equities, etc.
Correlations between various markets from December 2019 to December 2020
Source: Bloomberg
Hence, in an environment where asset classes are especially closely correlated, it is even more crucial to build a portfolio based on strong convictions.
Credit research (of individual issuers), whether it looks at a country’s public accounts and sovereign risk or at a companies’ financial statements is therefore an essential tool in identifying pockets of resilience in the investment universe.
To generate value, fixed income management generally has three drivers of performance at its disposal: i) duration, ii) spread and iii) currencies. With rates now going up, we believe it is important to limit portfolios’ exposure to duration risk and to focus our investments on spreads and currencies.
For example, in the recent period, high yield debt, in particular issued by companies in developed economies, should help enhance expected returns but without exacerbating duration risk. Identifying convictions makes it possible to exploit this pocket actively. Meanwhile, at the level of sovereign issuers, observing economic indicators brings to light those economies whose currencies are likely to appreciate. In both cases, the carry trade enhances returns.
Illustrations: between issuer creditworthiness and an asset class’s technical features
Let’s take the example of the monetary policies of emerging market countries. Generally speaking, during the 2020-2022 period, those countries that tightened their monetary conditions and kept their deficits from worsening, as well as those that, at the same time, exploited the pandemic-exit cycle, saw their currencies boosted by positive investment inflows and were relatively stable compared to other countries.
This was the case of Mexico, for example, which in order to defend its currency and in anticipation of coming inflationary pressures, launched a pre-emptive tightening, thus beating the ECB and Fed to the punch. These measures, along with the Mexican government’s fiscal austerity boosted the peso, which thus became a source of diversification and stabilisation for a bond portfolio.
Mexican key rates
Source: Bloomberg
Meanwhile, the improvement in external accounts, as reflected by the current account balance, and control of fiscal spending and debt underlay the Mexican peso’s relative attractiveness vs. the Colombian peso.
Comparative analysis: selected economic indicators for Mexico (MX) and Colombia (CO)
Source: Bloomberg
MXN and COP exchange rates (vs. USD)
Source: Bloomberg
High yield debt is another example. Keep in mind that a short-dated, high-yield issue is automatically less sensitive to rate fluctuations.
At a time when core euro zone sovereign debt became risky amidst low yields (i.e., 0% or even negative) and hence with historically high sensitivity (with modified durations of about 9), taking on exposure to targeted issuers in this segment helped mitigate a portfolio’s volatility, thanks to issues with relatively high yields on relatively short maturities.
Relative performance of High Yield issues compared to Eurozone sovereign debt
Source: Bloomberg
Conclusion
Inflation remains public enemy no. 1 on our markets. Monetary authorities had made it a matter of honour to see it through. Speculation is rife regarding the timing of the famous pivot by the Federal Reserve and by the ECB. The timing of the pivot will depend on inflation stabilising and then receding and converging towards 2%.
A bond’s very essence consists not only in the principle of repayment upon maturity, but also on accrued interest. And, in fact, regardless of the economic context and the direction taken by the markets, identifying issuers with viable solvency and liquidity criteria allows a bond strategy to ultimately achieve more resilient returns and, to a certain degree, to free itself from economic cycles, as well as market fluctuations, which can be (intensely / highly) erratic.
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[1] The equation M*V=P*Y formalises this theory (M being the quantity of money in circulation, V the velocity at which this money circulates, Y production and P the price level). The monetarist theory states that expansion in the money supply is the cause of higher prices and that inflation is therefore a monetary phenomenon. To Milton Friedman, the fight against inflation, called public enemy no.1 by Gerald Ford in 1974, requires shrinking the money supply and raising interest rates.
[2] The gap vs. projected spending is arrived at by calculating the change in percentage between fiscal spending of each government in 2020 and a value projected for 2020. The projected value is calculated by taking the average growth rate of fiscal spending between 2015 and 2019 and making forecasts one year out.
[3] The Phillips curve theorises the relationship between inflation and the job market in stipulating that a higher inflation rate comes with a lower unemployment rate, and vice versa.
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