Emmanuel Petit
General Partner, Head of Fixed Income
In the first quarter of this year, investors were wondering whether central banks would be able to rein in inflation. The last three months have shown that the danger now lies in potential over-optimism.
The glass half-full
It has been quiet sailing on the markets in very uncertain waters. A split has, in fact, emerged between the signals emitted by the fixed Income market and the assessment of risky markets. Risky markets seem very confident that central banks will be able to control inflation without significantly undermining the economy or triggering a recession. We don’t believe in this scenario, but it does seems to be the currently predominant. As an example, fears surrounding the banking sector have faded rapidly, and key rate forecasts have returned almost to levels that prevailed prior to the collapse of Silicon Valley Bank and Credit Suisse. This event is now considered an epiphenomenon.
In general, we are seeing relative complacency regarding the current uncertain environment. This is showing up in risk premiums, which remain rather narrow, and in low levels of volatility. Even so, the yield curve has become even more inverted than it was in the first quarter, and to a degree not seen since the Volcker period. The long section is stuck in place, suggesting that inflation expectations are still anchored (10-year forecasts are currently at 2.25%(1)). This situation illustrates how much confidence the markets have the central banks.
Too much confidence?
Central banks now face a new task – to avoid euphoria spreading through the markets. Aware of the risks inherent in excessive optimism, they are hammering away at a message of hawkishness, with their paramount goal being to get inflation back to their 2% target. But yet, the Fed has opted for the status quo in its tightening cycle – In March the central banks of Canada and Australia had done likewise before resuming their rate hikes. The mystery is even greater as the language is more hawkish than during the months preceding this decision. Moreover, the Fed is still projecting two consecutive hikes, while the markets are now pricing in just one. There is always a lag between the implementation of a monetary policy and when its effects show up. We are entering a phase in which we will be assessing, month-by-month, the impact of the latest decisions, especially as a disinflationary trend seems to be beginning. Indeed, this could suggest that the situation will gradually “normalise” without the steep rise of previous months having had a major impact on the economy.
Hard to get a true read
In the US, economic activity is holding up, inflation is receding slightly, and the labour market is still robust. And yet, the spectre of recession continues to hover. All leading macroeconomic and market indicators are pointing in that direction, and things have worsened again since late March. The consequences of the rate hikes cannot be overlooked, especially as financing conditions remain clearly restrictive. Meanwhile, PMI(2) services indices are trending downward but for the moment are holding above 50. PMI manufacturing indices, however, are under this threshold. Historically, the services indices tend to track behind the manufacturing indices, and on both sides of the Atlantic.
Even so, inflation is receding far more slowly in Europe than in the US. So, the context is more challenging for the ECB and offers investors less visibility on the “landing point” of its monetary policy. This lack of clarity is being maintained by the cyclical lag between Europe and the US. In raising its rates higher and faster, the Fed has managed to achieve results that are now tangible. In Europe, the situation is more nuanced. However, if the US slips into a recession, European long-term rates yields will track US long-term rates yields downward, although the ECB says it will continue to hike.
A prudent and selective strategy
Against this backdrop, we have raised the portfolios’ interestrate sensitivity to quasi-neutrality vs. the market. However, we are avoiding overweighting interest-rate sensitivity, as Europe is still in a negative real-rate environment and it is impossible to know how ECB monetary policy will “land”. We have also reduced the portfolios’ tracking error(3) in general, lessening their exposure to risky assets by selling high-beta bonds. Hence, after having overweighting very-long-dated sovereign bonds in order to hedge risk at attractive absolute levels, we have shifted our allocation to five-year paper, as the yield curve has inverted even more, and have taken this opportunity to raise portfolio sensitivity slightly. This positioning seems to fit a potential shift in monetary policies.
Meanwhile, we are overweighting sectors such as banks that are able to use the latest interest-rate movements to generate considerable profits and that enjoy solid fundamentals. Similarly, we are opportunistically investing in bonds with attractive yields. We are invested in all Investment Grade(4) ratings but the more we descend the scale, the more we try to identify positive credit trajectories and a potential for improvement in fundamentals to provide some resiliency to the portfolios. For the most flexible funds, we prefer to retain some leeway for positioning ourselves on riskier investments when during surges of volatility.
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