Emmanuel Petit
General Partner, Head of Fixed Income
After more than one year of monetary tightening that has been exceptional in both its extent and its speed, the ECB has flagged that this cycle, the most hawkish since its inception, is probably coming to an end.
The end of monetary tightening?
Over the past period, measures taken to slow inflation have sent interest rates to more than 500 basis points (bps) in the US and more than 400 bps in Europe(1). However, each day it looks increasingly likely that this monetary tightening cycle is coming to an end, as current levels of interest rates and restrictive credit conditions are causing investors to price in a soft “normalisation” of monetary policy, with rates staying at their current levels for several months before possible cuts in the middle of next year.
Hard or soft landing?
Leading indicators are sending out worrisome signals, with the PMI manufacturing staying below the critical threshold of 50 since the start of the year(2). PMI services are on a similar trend, converging towards levels that point to economic trouble.
A disinflationary cycle featuring both hope and uncertainty
The disinflation cycle now appears to have begun in the US, even though inflation is still above 4%(3), far above the Fed’s 2% target. There have even been signs of recovery, particularly in the energy and commodities sectors, including higher oil prices. Meanwhile, real-estate prices are holding up somewhat and the job market, whose role is decisive in inflation within the services sectors, has cooled off.
In Europe, structural inflation has levelled off, but with core inflation(4) lagging behind, due mostly to resilience in services. Although momentum has recently slowed, inflation is expected to stay high in late 2023 and remain far above the 2% target until the end of 2024(5).
Rising sovereign yields
With these stubborn inflationary pressures, nominal rates have soared, particularly in late September, peaking at 4.6% in the US and at 2.9% in Europe(6). Levels like these had not been seen since, respectively, 2007 and 2011(7). Accordingly, it may be wise to consider investing in sovereign debt, particular in anticipation of a potential recession. For, historically, during economic downturns assets deemed risk-free tend to perform well, offering solid protection for investor portfolios while generating a yield set by real rates.
How we are positioned on the credit market
The market is currently offering attractive yields, thanks to the rise in sovereign yields since 2021. To take one example, European Investment Grade(8) bonds are currently yielding 4.2%(9), a level similar to that seen at the peak of the 2011 financial stress. High Yield(10), meanwhile, is on a nominal yield of 7%(11). However, it is essential to carefully analyse risk premiums in view of a possible cyclical downturn.
In our investment strategy, we have taken a moderately conservative approach, overweighting Investment Grade vs. High Yield, due to its close correlation to sovereign yields. This historically generates noteworthy positive returns after the end of monetary tightening cycles.
There is currently little difference in yields between cyclical and non-cyclical companies. Our strategy consists first in enhancing the aggregate quality of corporate bonds in our portfolio by overweighting, for example, A ratings vs. BBB ones, and then identifying issuer vulnerabilities borne of the economic cycle. On this basis, we exclude them from our portfolio and focus more on non-cyclical issuers.
Launch of our ninth and 10th generations of targetdate funds
R-co Target 2027 HY is a fund based on a strategy of holding bonds until maturity. It is invested in eurodenominated High Yield(1) bonds. This buy-and-hold strategy(2) is based on a selection of bonds whose average maturity is between January and December 2027. Based on the same management principles, R-co Target 2029 IG invests in euro-denominated Investment Grade(3) bonds from all geographical regions. They mature between January and December 2029. Distribution of these two funds lasts until 31 December 2024.
(1) High Yield bonds are issued by companies or governments having a high credit risk. They are rated below BBB- by Standard & Poor’s.
(2) Buy and hold: An investment strategy consisting of buying securities and keeping them until maturity.
(3) Investment Grade bonds are issued by companies or governments rated between AAA and BBB- on the Standard & Poor’s scale.
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