JP’s Journal: The central bank dilemma

I could write more about the geopolitical situation, but I think it is time to ask: How are RLAM strategies doing and what are their prospects in these uncertain times?

Clearly the latter is dependent upon assumptions about how and when the crisis is resolved and the impact on inflation and growth.

The year to date (YTD) performance figures for fixed income assets don’t make great reading. US treasuries are down 2.5%, with German bunds and UK gilts both off 4% plus (local currency, 10-year bonds). Credit has fared poorly, with spreads wider in all geographies and sectors. In sterling, for example, investment grade non-gilt spreads have moved out from 96bps at the start of the year to 126bps as I write. In high yield, my preferred credit spread index has widened to 5%, after a low in recent months of 3.5%.

Our strategies have reflected these moves. In our cash and shorter duration range the move up in short yields has impacted; this is particularly the case for those with credit exposures. However, we believe the yields we are now seeing embed the expected tightening in monetary policy. In our government portfolios returns have been negative but relative performance has been broadly in line with indices. Our absolute return government strategies have lagged a bit, reflecting an underweight position in UK inflation.

Similarly, our credit range has broadly tracked indices year to date, after giving up some ground in recent weeks. This reflects the bias towards financial bonds that is a common feature of many of our funds. And you can see why. Bank and insurance company capital ratios have been on an improving trend, they are not at the epicentre of the ESG / climate debate (yet) and credit spreads are generally wider than those of non-financial companies. Our strategies are generally overweight subordinated banks and insurance bonds, but they have underperformed in recent weeks. Why is this?

The Ukrainian crisis has led to a risk-off phase in bonds and equities. As banks and insurance are high beta sectors (i.e., they react to market direction moves more than average) spreads have widened more than those on indices. So, if we look at a 10-year subordinated sterling bond from HSBC, for example, we can see that the spread has moved out from 1.2% to 1.8% over the last two months.

Other issuers, with greater exposures to Russia, have fared worse. I have to say that we remain overweight subordinated bank and insurance debt. But it is important to maintain sector diversification. Sometimes you can have too much of a good thing – and positioning in financial bonds is a case in point for sterling credit.

Before looking at the prospects for fixed income strategies it is worth considering the dilemma that central banks face – one encapsulated by the European Central Bank (ECB) last week. Whilst acknowledging that the Ukrainian crisis was a “watershed for Europe” and promising to ensure smooth liquidity conditions the ECB indicated that they may accelerate tapering, thereby allowing earlier than expected interest rate hikes. They now see 2024 inflation at 1.9%, very close to target. We are sticking to our forecast of a 25bps rate hike in Q4, but things can change quickly. The Bank of England (BoE) and the Federal Reserve face the same issue. In the immediate aftermath of the Ukrainian invasion markets “took off” two rate hikes; this has now been reversed. If we look at what is priced, we can see that the markets are seeing US and UK rates at around 2% in 12 months’ time.

Oil price shocks usually presage economic slowdowns. Given the squeeze on disposable income we will see and the already low level of growth forecast for 2023 and 2024 it would not take a lot to tip the UK into recession. So should we buy long-dated UK bonds? Not really. In my view, real yields are too low for the greater supply that is coming our way, with little prospect of the BoE stepping in to neutralise. Admittedly, if the BoE is right on its inflation forecasts, they may have some leeway in the future but the thought of renewed Quantitative Easing (QE) when inflation is where it is does not fly. In any case we have to wean ourselves off the Magic Money Tree.

So, I am keeping faith in credit but ensuring that our strategies are properly diversified and have duration towards the lower end of ranges, while not losing sight of opportunities that arise in situations of adversity and stick to tried and trusted investment approaches. In practice, my favoured strategies are shorter dated credit (both investment grade and high yield), those that have strong income generation and strategies that are flexible enough, such as absolute return approaches, to respond to changing economic circumstances.

Past performance is not a reliable indicator of future results. 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.