Known unknowns and the ghost of inflation
Market conditions were generally favourable throughout most of September until the FOMC meeting. Even after the release of the FOMC statement, markets remained relatively calm. It was only when Powell began speaking and responding to questions as if he were imparting a lesson, that the volatility seen earlier this this month turned into a significant directional sell-off. From our perspective, it was not the message that the FOMC is awaiting data clarity that rattled the markets. Furthermore, resuming rate hikes if the economy remains robust is not a major concern. What raised eyebrows was the degree of certainty Powell conveyed. He left the impression that he and the committee were highly likely to be correct in their analysis, and that the case for not cutting rates anytime soon was clear. However, such clarity doesn’t exist. Given the extensive money supply, the Fed’s inaccuracies in predicting inflationary outcomes and the structural changes in the US economy, nobody can be very certain about the future, When Powell expresses excessive confidence, there is a risk that events will need to deviate significantly from the FOMC’s expectations to prompt a change in their plans. Since market prices are rooted in probabilities, such confidence becomes a recipe for heightened volatility, increased risk premiums and expanding term premiums. One noteworthy result of this renewed sell-off is illustrated in Figure 1: US 30-year government bonds issued in May 2020 trading below 50, an honour normally only assigned to junk bonds with high risk of default. The 10-year bond from the same cohort has “only” lost 20% of its nominal value. Subtract the excess inflation created in the process of Fed squandering its institutional credibility, and the real value loss is now 30%+.
Figure 1: US government bonds losses from time of issuance in 2020
As seen in figure 2, Fed pausing has not stopped the monetary tightening. Yields on the 10-year US treasury and the 10-year German Bund have continued to rise. For investors, the question is therefore again how to protect, and later grow, invested capital. For many commentators, private market funds and wealth management employees, the answer seem to be private market credit. This is a good way of protecting their jobs, but we find it debatable if this illiquid “junk credit” is suddenly a great idea for every UHNW, HNW and affluent investor. And we remember more than one house where Chinese high yield bonds were seen as “the future” a few years ago. This risk in private credit is now so obvious that that FT on September 28th published an article titled “Moody’s warns on “systemic risk” from leveraged lending market”. Within this segment, our preference leans toward high yield and senior bank loans rather than private credit.
As part of our risk management, back in June we reduced our equity positions in multi-asset mandates, reduced our exposure to high yield bonds in fixed income strategies and bought short-duration high-grade bonds. In multi asset strategies our bond duration is around 3-3.5 years. In our most cautious fixed income portfolios, we have maintained durations as short as 1.5 years. This largely shielded us from the sell-off in the bond market where the Euro Agg and the US Agg declined roughly 2% and 2.4% respectively in September. Recent data has shown further declines in inflation. Still, the most important question for the direction of market is if central banks will take responsibility and manage monetary policy in a balanced way, or if they continue to “play it safe” and tighten further under cover of “the ghost of inflation”. As we see high risk that central banker will continue to prioritise the safe option over the millions of low-end jobs in cyclical sectors they are putting at risk, we refrain from the temptation to buy longer duration for now.
In our growth strategies, with up to 100% equities, we hold equity allocations close to neutral levels, around 60% with a large US weight. In the UCITS fund EDGE Sustainable Growth, these positions remain concentrated in the low-pollution, high-growth sectors, such as IT and Healthcare.
In our more cautious multi-asset strategies, we reduced our equity allocations from 50% to around 30% in late June. We maintain significant holdings in high yield bonds in these strategies.
Across our Global Fixed Income Opportunities portfolios, we have reduced our overweight in high yield bonds by allocating 20-30% to high grade bonds. We maintain a short duration.