JP’s Journal: Who stole the rate rise?

This week I am breaking with established convention and highlighting the things I got wrong recently.

The inflation resurgence

I did not see inflation rising as much as it has. So, what did I misjudge? It is easy to blame the Russian invasion of Ukraine as the cause. Higher oil and gas prices have certainly played a major part. But it is not the whole story. I underestimated the supply side disruption that arose as countries dialled down their Covid restrictions. That, in itself, was probably based on an underappreciation of the 2020 cutbacks. I certainly got labour market trends incorrect. Where have the workers gone in many developed economies? Tightness in the workplace has undoubtedly made the inflation situation worse. But we have to be careful on apportioning blame. Yes, Brexit has impacted certain sectors but total net migration is higher. Food price inflation has not surprised me; I have written about how cheap food is coming to an end in the UK. However, it has exceeded my expectations – made worse by those big increases in energy and transport costs.

The speed of interest rates rises

As a long-term bear on real and nominal government bond markets I have struggled to come to terms with negative or very low yields. My stance has been that we are in for a period of relatively low growth, in which interest rates and bond yields would rise, but remain low by past standards. So good marks for being on the right side of the move but points taken off for underestimating the speed and severity of the move up in yields. I should have been shorter in my relative duration positioning.

Credit spread widening

As an advocate of the benefits of credit bonds over government bonds, the last six months is a good reminder that credit is not a one-way bet. Yes, in the long term it is likely that the extra yield will compensate for defaults, but in the short term a 50bps plus widening in yield premia will outweigh the carry. So, my view that non-gilt investment grade credit spreads for 2022 would be in a range 100-150bps has proved wrong with the actual spread ending the half year at 158bps.

Within sterling credit there have been some good calls: our exposure to asset backed and secured bonds has really paid off. Conversely, the overweight position in financial bonds (banks and insurance) has been painful. The re-pricing of senior bank debt so far this year has been one of the key stand out features. The picture in high yield is worse. My view that sub-investment grade bonds would deliver better returns than investment grade or government bonds (higher yield and an acceptable default profile) has been undermined by the near 300bps increase in spread.

I think I have been pretty in-tune with growth trends. I was sceptical of the ‘big bounce’ widely expected for 2022, fearing that the savings accumulated through lockdowns would not be spent as readily as forecast. I have been worried by geopolitical developments, but more focused on China than Russia. I don’t see a quick resolution in Ukraine and think that US-China friction will be the major political theme of our time.

And the effect on markets

So, what did returns look like in the first half of this year? The answer is grim. UK government bonds and global high yield at -15%, sterling non-gilt -13% and even short-dated strategies have been hit, with the short-dated sterling indices returning -5%. With inflation around 10%, these are pretty significant negative real returns. The faint hearted better not look at UK index linked bonds. There to offer inflation protection, the longest dated UK index linked gilt gave a return of nearly -50%.

Markets are funny beasts. Just as I had got use to talking about US curves factoring in 3.75% Federal Reserve (Fed) Funds by early 2023 they start factoring in a hard landing. What this means is that in the space of three weeks we have lost 75bps of monetary tightening in the US. In the UK the profile is the same, with at least two 25bps hikes taken off the table. So, at the end of last week we had German 10-year yields at 1.23%, US at 2.88% and UK at 2.08%, all off 50-60bps from their June highs.

The answer is recession fears have ‘stolen’ the rate hikes expected further out. Markets are pricing in a slowdown which will be sufficient to moderate inflation and allow central banks to go easy on punitive tightening. If only things could be so simple. I don’t see inflation coming down without a big change in labour market conditions. Unless the Fed is fibbing they will push rates higher than is now being discounted. This is not a reason to be automatically bearish on 10-year rates but it is unusual for a recession to be priced in without real economic pain being felt. Are markets a super-discounting mechanism or just wrong?

The pain is now being felt in credit markets. There was another move wider in both investment grade and high yields spreads last week and there were pockets of distress that we had not seen for some time. Whilst financials remain under pressure we saw a further sell-off in corporate hybrid bonds and significant weakness in junior REIT debt (real estate trusts). Markets are now pricing many such bonds as perpetual, with early calls unlikely to be exercised. Such is the outcome when bonds are issued in an environment of near zero interest rates and investors are chasing yield. This pricing does not bode well for capital values in the property sector.

Past performance is not a guide to future performance. The value of investments and any income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice.