Time to reflect on the quarter. Government bonds have been badly impacted by the rise in interest rate expectations, a product of inflation and more hawkish communications from the US Federal Reserve (Fed).
The war in Ukraine has worsened existing price trends and has given central banks a real dilemma: tighten policy to address inflation or give some slack on further policy moves until the growth consequences become more evident.
If we look at what is currently priced in over the next 12 months we can see that US investors are positioned for a Fed Funds target rate above 2.5%, compared with the present 0.5%, implying eight hikes. In the UK the picture is only marginally different: seven hikes and a rate of 2.5%. In the eurozone there has been a significant shift, with tightening now expected in the second half of the year.
What this has translated into is a -7.5% return from all maturity UK government bonds, -6.2% from investment grade sterling credit, and -5.4% from index linked gilts. The pattern is the same elsewhere: -4.9% for US treasuries, -4.6% German bunds and -6.3% in Australia (all local currencies). The UK looks worse but reflects the longer duration of the sterling government market. The long ends of bond markets have been more severely impacted; if we look at over 15-year index linked gilts the return is -8.5%.
High yield markets had a bumpy ride, with the Chinese real estate problems casting a shadow with the Russian invasion of Ukraine compounding the situation. And yet the total return from global high yield was broadly in line with the pattern seen in fixed income markets. Spreads widened just over 50bps at a mainstream index level, giving a return of -5.6% (in US dollar terms).
So, the quarter was bad for all fixed income assets. The usual safe havens of government bonds (nominal and index linked) did not work. Taking the UK 50-year real yield we can see the reason: yields rose 40bps. There was slight mitigation in that implied inflation went higher – but nowhere near enough to offset the move in real yields. For nominal bonds, higher implied inflation and rising real yields were a painful combination. The 2061 gilt, issued in May 2020, has now lost a third of its value since issue, ending the quarter at £67.
Our fixed income strategies reflected the trends seen in markets. In general, our credit outperformed benchmark indices. There was not much impact from sector selection with underweights in supranationals and overweight in financials both being unhelpful. Security selection was the main driver of relative performance, especially exposure to secured bonds. Government strategies tended to add value with a bias towards having duration below benchmark levels being beneficial. However, we were caught out a bit by the sharp rise in UK inflation expectations, a move more pronounced in the UK than in other major areas.
Looking at last week, data was mixed. US non-farm payrolls fell short of expectations but there was an increase in participation and a bigger than expected fall in the unemployment rate. Now at 3.6%, the unemployment rate is back to pre-Covid levels. A tightening labour market was reflected in a rise of 5.6% in US wage inflation. There was nothing in these figures to deter the Fed from another move at the next meeting.
The most striking data releases last week was the German Consumer Price Index (CPI), which moved above 7%, the highest level in 30 years. Europe is significantly exposed to higher energy costs, adding to existing trends brought about by supply chain disruption, higher food prices and a pick-up in activity as lockdowns recede.
Credit issuance picked up towards the end of the quarter, after a lull due to market volatility. In sterling we have seen banks coming back, but at higher spreads than in previous months. To this extent the move wider is now being confirmed by issuance at these new levels. This highlights one of my themes: we like financial bonds (banks and insurance) but correlations are high in these sectors. When building out credit strategies, proper diversification is really important.
Moving past the first quarter
So, what is the outlook? The inversion of the US yield curve (2-10s) got a lot of attention last week – seen as a precursor of recession. I think we will see a slowdown through 2023 and 2024 and is one reason I cannot get too bearish on government bonds. However, I still want to keep duration below benchmark and prefer credit to governments.
On a completely different matter, I have just started my 38th year at Royal London (having joined on the 1st April 1985, before RLAM was established!). Clearly much has changed over the years, but from an employment perspective I think one big development is flexibility. Not just in hybrid models based around working from home but in the expectation of having a range of jobs and careers. The quality of people coming into RLAM continues to impress me – I don’t think I would have been given a job in 1985 if I was against the current crop. This gives me confidence that the future of RLAM is really bright.
Good luck to Ash Barty. Quitting competitive tennis at 25 shows how things change.
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.