From our perspective as fixed income investors, our base case scenario is that we are going from an ‘inflationary boom’ to an ‘inflationary bust’. After more than a year of post-COVID recovery, we had to deal with increasing inflation due to disruptions in supply and demand. This was the inflationary boom. Now, with the Ukrainian war, we must deal with an additional inflation push. Our previous base case scenario of normalising prices has, at best, been postponed. There is a risk that we must now deal with significantly larger second round effects. This means inflation expectations could stay elevated or increase structurally. Inflation will have a direct impact on consumer spending.
Consumers were in a healthy position, with significant fiscal support and a strong job market…until inflation started eating away at their spending power. Now we must add the uncertainty of the war in Ukraine to our models. Company earnings might also be impacted, as they will struggle to keep passing on the inflation of input prices to their output prices. Geopolitical uncertainty is not great for capex, so some of these plans will likely be delayed.
It is very difficult to assess how the combination of high inflation and negative sentiment will drive economic growth downward. But it will. An inflationary bust is on the cards.
What is the economic outlook from a fixed income perspective?
The war has led to terrible human tragedies. Apart from the brutality of the war, the impact on inflation and general economic uncertainty are having an important impact on fixed income markets.
The Fed had already pivoted towards a full focus on inflation, and the ECB followed suit. Hence, we were already expecting a hiking cycle. With the additional push on inflation, these central banks are likely to start tightening as planned. But we don’t think they will get very far. Based on our current outlook, we don’t see the Fed hiking much in 2023 anymore. Similarly, the quantitative tightening will start as planned, but, by 2023, they will have to stop tightening, as the economic impact from the Ukrainian conflict likely merits a more accommodative stance.
On the back of these tightening expectations, and the rate volatility that followed, credit spreads had already been widening since the end of 2021. Similarly, in emerging markets, which were tightening much earlier, we saw interesting opportunities as yields became very attractive.
With the onset of the Ukrainian conflict, credit spreads have been pushed higher and, in emerging markets, particularly Eastern Europe, valuation adjusted sharply.
In terms of currency effects, the Euro has strongly underperformed compared to other major currencies, even compared to the Swiss Franc. This is clearly related to its proximity to the conflict and the relatively higher dependence of the European economy on Russian trade.
Is it important to note how some currencies have rallied strongly, including the New Zealand Dollar, the Australian dollar, the Brazilian Real and the South African Rand. This is clearly on the back of a rally in commodities, from which these countries stand to benefit.
Many of our fixed income portfolios have an important overweight or allocation to the USD, CHF, AUD, NZD, etc. from which they have benefitted.
How has the ESG framework protected our portfolios on the bond side?
On the bond side, the most directly impacted assets where Russian and Ukrainian government bonds. Having said that, many bonds in the Central and Eastern European region have suffered disproportionally. We take sustainable investing in government bonds very seriously. What is the basis of our country sustainability approach? Simply speaking, a sustainable country meets the needs of the current generation without compromising the ability of future generations to meet their own needs.
This sustainability framework for government bonds is based on an in-house model, that aims to establish the Environmental, Social and Governance credentials of each country. On the back of this model, we have been successfully managing government bond portfolios in developed and emerging markets for over 15 years.
But I do not necessarily want to focus on this model, though it has served us well in providing a framework for well-balanced portfolios. Instead, I want to point to one observation: no matter how good or bad the current ESG credentials of a country, if it is not democratic, these credentials are meaningless. An authoritarian leader is unlikely to prioritise the ability of future generations to meet their needs. Based on our previous definition of a sustainable country, we automatically exclude non-democratic or authoritarian countries from our investible universe. Only then do we apply our country sustainability model.
Which countries are excluded? To avoid biases, we rely on independent external expertise. When Freedom House gives the ‘Not Free’ label to a country, and the Economist Intelligence Unit democracy index confirms that said country is ‘Authoritarian’ as well, we de-facto exclude it.
This means we do not invest in government bonds from countries like Belarus, Egypt, Iraq, Kazakhstan, Saudi Arabia, or Venezuela to name just a few. We also exclude Russian government bonds.
Hence, DPAM strategies entered this crisis without any Russian government bond exposure, not in hard or local currency.
For full details, you can refer to our Controversial Activities Policy our website, where you can find all the details. The absence from Russia has helped us significantly in terms of performance in emerging markets and other strategies.
What does that mean for fixed income positioning?
Unfortunately, for our base case scenario, we have to conclude that the war and the terrible human situation will continue for some time yet. We do not see a quick resolution of the conflict.
Therefore, we will keep a cautious stance for the time being. It is too early to re-enter to pick up riskier assets at a cheaper price. It means that we remain neutral on high yield and investment grade credit. It must be said that investment grade credit is possibly better protected, as the ECB might intervene and re-ignite its corporate bond purchase programme, potentially providing a floor for pricing. Credit spreads are very sensitive to expectations of corporate profitability and financing conditions. Both are likely to remain under pressure in the near future.
The picture for interest rates is a bit more complex. Interest rates have been subject to upward pressure for the past few months. This was mainly driven by higher inflation and expectations of Fed tightening. So, nominal interest rates are already pricing in a tightening cycle.
With the current continued inflationary upswing, one would have expected higher nominal rates. But, combined with a risk-off move, nominal rates went down slightly during the start of the Ukrainian war. The real escape valve were real rates. Prior to the invasion, German 10-year real rates were about -1.7%. They dropped to -2.7% at some point. So, the real ‘risk off asset’ in this crisis has been inflation-linked bonds. In fact, given the continued high inflation prints and high inflation expectations, it is the first time that inflation-linked bonds are making a real important difference in investor portfolios. Over the past 30 years, ever since inflation-linked bonds first appeared on the markets, inflation expectations have been relatively stable, and inflation-linked bonds never strongly outperformed. This time is clearly different.
Does that mean we see continued value in inflation-linked bonds? Before the Ukrainian war, we had decided to keep a position in inflation-linked bonds as it protected us against inflation uncertainty. The position has paid off, but uncertainty remains. We will, in the short term, keep the position in inflation- linked bonds, as inflation uncertainty remains elevated.
Emerging markets in hard currencies have been impacted by the widening spread. For emerging markets in local currency, the picture is more nuanced. The Rubble and Eastern European currencies have suffered. However, many others, including Latin American and Asian currencies, have rallied. Interest rates held up quite well initially but have recently sold off. Nonetheless, emerging markets in local debt, outside of Europe, seems to be an interesting diversifier in terms of riskier assets.
Overall, where possible, we prefer to keep our allocations to these safe havens and focus on commodity currencies as an additional layer of protection for the portfolios. Basically, we move our exposure away from the Euro.
It’s worth noting that we do not think the reserve currency status of the USD is under thread for the time being.
In conclusion, we unfortunately do not see a swift resolution to the Ukrainian crisis.
One the rates side, we remain cautious with an underweight duration stance on the back of inflation pressure and the release of the risk-off pressure. Inflation-linked bonds have become more expensive, but we keep them for the time being as inflation uncertainty is high.
On the credit side, we find it too early to enter and add more credit at wider spreads, despite the value that has been created.
On emerging local currency, we see similar value being created, but the uncertainty in Central Europe is too elevated to increase our positions for the time being. Further away, we continue to see better value, in places like Latin America and Asia.
