Outlook and Portfolio positioning
February was the month during which global bond markets wobbled, sparking a general retreat in many other assets and injecting a note of uncertainty into the previously upbeat mood that the year began with. In many ways, the sell-off in the bond market was rational, even expected, as the safe-haven premium that was built into these assets during the Covid crisis is simply just unwinding a little, as the prospect of a return to normality comes ever closer.
In absolute terms, the bond market sell-off we saw in February moved ‘risk-free’ government bond yields up from 1.0% to 1.4%, in the USA, and up from 0.3% to 0.8%, in the UK. These moves leave them roughly back in line with where they were before the Covid crisis erupted a year ago. Given that we are very close to the re-opening of both societies, that does not seem too unreasonable a reaction, at least on the surface.
“In many ways, the sell-off in the bond market was rational, even expected, as the safe-haven premium that was built into these assets during the Covid crisis is simply just unwinding a little, as the prospect of a return to normality comes ever closer.”
However, the fact that this reversal was crammed into just one month was unnerving, as it had the potential to catalyse a further sell-off, and one that would be much less rational in nature. The thinking here is that the reopening of economies would release enough pent-up demand to push inflation up quickly and sustainably, leading eventually to the authorities raising interest rates.
The prospect of higher interest rates is really what is unsettling the financial system currently, as the colossal amount of debt that has been issued by governments to support society during lockdown is easy to service when rates are so low, but not so easy to service if the market starts to demand higher rates to compensate for inflation.
Ultimately, given that the central banks have repeatedly communicated how they are in no mood to raise interest rates and given that we are so early into the recovery cycle, it feels a little premature to us, to worry about runaway inflation risks at this point. Multiple years of trying to achieve modestly higher inflation levels post the 2008 financial crisis have broadly failed, suggesting that there are deep, structural forces at work pressing down on prices, however hard the authorities try to raise them up. Stronger economies should also be able to cope with higher interest rates, making us think that what we are probably seeing now is more of a rebalancing in market leadership than something more sinister. Effectively the ‘Covid winners’ of 2020 (which include bonds) are giving back some of their gains, and the ‘Covid losers’ are recovering some of their losses in early 2021 as the environment steadily improves.
This kind of rebalancing is taking place across asset classes and geographies and it is no doubt going to be a bumpy period, but still one which we think is capable of generating positive portfolio returns. The volatility we are now seeing is throwing up opportunities in assets that were previously too expensive to consider and whilst we aren’t moving yet to actively purchase them (as the wobbles will probably extend into the next few months) we are minded to do so soon.
“This kind of rebalancing is taking place across asset classes and geographies and it is no doubt going to be a bumpy period, but still one which we think is capable of generating positive portfolio returns.”
Portfolios delivered between -1.0% and +1.6% over the month, with the lower risk portfolios (which have more bond exposure) losing the most. Although higher risk portfolios were affected by a late sell-off in stock markets, gains made earlier in the month were enough to keep these mandates broadly in positive territory. The relative losers aside from bond managers were assets such as gold (which doesn’t tend to enjoy a rising yield environment), and ‘quality company’ focussed stock managers, as this type of style is often viewed as a ‘bond proxy’ given the steadiness of profit and dividend growth and therefore falls out of favour when bonds are in retreat. Among the best performers were the convertible bond arbitrage managers, who look for dislocations between a company’s equity and debt, and as global debt sharply repriced, they saw a number of compelling investment opportunities.
On behalf of the Saltus Investment Committee, February 2021
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