Inflation fears take markets by surprise

BY ERIC VANRAES

Monthly Fund Commentary
23 Mar 2018

BY ERIC VANRAES

On 2nd February, average hourly earnings rose by 2.9% YoY (the most since 2009), leading market participants to immediately modify their inflation projections and revise their Fed funds’ forecasts. Throughout the month, US Treasury yields rose significantly, causing a correction in equity markets and a sharp increase in volatility.

The minutes from the FOMC meeting in January contained a more hawkish tone than expected. During his first testimony to the Congress, the new Fed chairman Jerome Powell mentioned that the FOMC “will continue to strike a balance between avoiding an overheating economy and bringing price inflation to 2% on a sustained basis”.

In Europe, German business confidence fell by the most in five years, likely as a consequence of the political instability and the strength of the euro against the US dollar. The ECB mentioned concerns regarding “recent statements in the international arena about exchange rate developments” and referenced their concerns regarding the weakness of the dollar.

STRATEGIC EURO BOND FUND

During the month, the Investment Adviser sold the remaining stake in Essilor (before the merger with the Italian Luxottica). More importantly, the team focused on managing the duration risk: 5 Bunds were sold on 2nd February after the release of the non-farm payroll (NFP) figures in the US. Additionally, 5 contracts were sold on 5th February and finally 5 Bunds were sold on the 23rd. Further, the short Bund position was increased to 55 contracts in February, resulting in a decrease of the the modified duration from 1.2 to 0.5. In terms of portfolio diversification, the Fund held 28 issues from 28 issuers. STRATEGIC GLOBAL BOND FUND In February, the Investment Adviser actively managed the duration overlay. The team sold 40 10y Note futures on 2nd February after the release of the NFP. On 15th February, the team bought back the short long Bond position and replaced it by a short 5y note position. Later in the month, on 21st February, the Investment Adviser sold 30 5y notes and bought back 35 10y notes on the 27th in order to increase the duration from 2.5 (which was too low) to 3.4. During the month, the Investment Adviser took the opportunity to invest in short term bonds, maturing in 2020 and offering a yield close to 3%. More specifically the following bonds have been purchased: Export-Import Bank of Korea (at 2.92%), Cnooc (at 2.94%) and EDF (at 2.95%). As a result, the modified duration decreased from 3.8 to 3.4 (with an intra month low of 2.5), with the average yield to maturity increasing from 2.5% to 2.8%. In terms of portfolio diversification, the Fund held 30 issues from 28 issuers.

STRATEGIC GLOBAL BOND FUND
In February, the Investment Adviser actively managed the duration overlay. The team sold 40 10y Note futures on 2nd February after the release of the NFP. On 15th February, the team bought back the short long Bond position and replaced it by a short 5y note position. Later in the month, on 21st February, the Investment Adviser sold 30  5y notes and bought back 35 10y notes on the 27th in order to increase the duration from 2.5 (which was too low) to 3.4. 

During the month, the Investment Adviser took the opportunity to invest in short term bonds, maturing in 2020 and offering a yield close to 3%. More specifically the following bonds have been purchased: Export-Import Bank of Korea (at 2.92%), Cnooc (at 2.94%) and EDF (at 2.95%). As a result, the modified duration decreased from 3.8 to 3.4 (with an intra month low of 2.5), with the average yield to maturity increasing from 2.5% to 2.8%. In terms of portfolio diversification, the Fund held 30 issues from 28 issuers. 

STRATEGIC QUALITY EMERGING BOND FUND

The Fund’s duration overlay was managed during the month in line with the strategy adopted by the Global Bond Fund. The team sold 60 10y Note futures on February 2nd after the release of the NFP.

On 15th February, the Adviser bought back the short long Bond position in order to replace it by a short 5y note position. On the 21st, the team sold 40 5y notes, finally buying back 40 10y notes on 27th February, in order to increase the duration from 2.5 (which was too low) to 3.2. At the beginning of the month, the Investment Adviser bought Lithuania 2020 and Latvia 2021 in order to reduce the large cash position, without increasing the portfolio’s beta during the volatility spike. Further, the Investment Adviser also bought South Africa 2027 at 4.93% when Jacob Zuma was forced to resign and replaced by Cyril Ramaphosa.

In terms of geographical breakdown, the top 3 countries were Mexico (14.4%), Russia (11.6%, the weight was increased in January as the Investment Adviser believed Russia would be upgraded to Investment Grade soon; with the upgrade taking place in February) and India (11.3%). The rating allocation was 79.1% Investment Grade, 16.3% Crossover (BB+ and BB) and 4.6% cash.

The breakdown of the portfolio in terms of market allocation was 91.6% Emerging Markets and 3.8% Developed Markets (i.e. Luxembourg/ArcelorMittal). In terms of sector allocation, the Investment Adviser favoured Governments (24.5%), followed by Materials (23.9%) and Energy (21.7%) . The modified duration decreased from 3.8 to 3.2 (with an intra month low of 2.5). In terms of portfolio diversification, the Fund held 36 issues from 36 issuers.

OUTLOOK

The Investment Adviser’s outlook remains tied to two major topics, inflation and Central Banks’ behaviour. In Europe and the US, inflation is historically low and likely to persistently remain below target. Recent economic data and US central bankers’ comments however suggested that inflation could be higher than expected in the months ahead. The Investment Adviser decided to keep the funds’ duration low and to actively manage the duration risk. This low duration policy is tactical rather than strategic, as the Investment Adviser still believes that the current economic situation in the US is probably at a turning point, at which equities are becoming less attractive and long Treasuries more interesting, despite increasing volatility due to lower levels of quantitative easing.

In Europe, tapering remains the main concern. As a result, corporate spreads could suffer substantially. The steepening of the Bund curve could persist, driven by inflation fears in the US and a too strong euro against the dollar.

In the US, the Investment Adviser still believes that long US Treasuries (10 to 30 years) will become increasingly attractive. The team thinks that they could be a top performing asset class in 2018 and that an inverted slope of the curve is not excluded by the end of the year. Any correction would be seized by the Investment Adviser as an opportunity to add positions for a medium-long term strategy (outright and/or purchase of 30y bonds hedged by a short 5y future position). The Investment Adviser thinks that the major risk, in the Treasury market, does not stem from macroeconomic data but from cash flows. Due to Mr Trump’s tax reform, the Treasury Department will need to issue more than USD one trillion of debt in 2018 (compared to 488 billion in 2017). Should an auction of Treasury notes go wrong, US yields could rise sharply, depicting a great opportunity to purchase government bonds at attractive yields. The Investment Adviser strongly believes the increase of US yields to be rather moderate and short-lived, as too high 10y and 30y yields would lead to an economic slowdown or recession in 12-18 months.

The views and statements contained herein are those of the Eric Sturdza Banking Group in their capacity as Investment Advisers to the Fund as of 13/03/18 and are based on internal research and modelling.