June 2022

“…the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates…to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”  The Federal Reserve Act

In previous commentaries we stated our belief that the degree of monetary tightening required to tip economies into recession is not significant.  In June we saw a concerted effort from central banks to accelerate hiking policies (Fed +.75%, BOE +.25%, SNB +.50% etc) while the ECB primed the market for action at the upcoming meeting in July, which set government bond markets into freefall in the first half of the month.  Inflation data continued to accelerate which also contributed to the risk off mood across all assets, and this sentiment accelerated when the first signs of slowing economies became apparent.  The latest monthly UK GDP release was negative, while mass layoffs swept across a number of industries and talk of a “technical recession” crept into the commentariat.  As a result, there was a strong rally in government bonds into month end while future rate hikes started to get priced out of yield curves, especially in Europe.  Perhaps this is a useful time to remember the Fed’s dual mandate and to ask the question of how committed they will be to “wringing inflation out of the system” in the face of a creeping slowdown and job losses.

Market reaction was understandably negative.  Equity markets capped off their worst start to the year since the Beatles split up, while credit market woes were compounded by illiquidity as redemption driven selling in high yield spread across other parts of the credit universe, leading dealers to be left with unwanted inventory and increased-VAR related position reduction.  This particularly affected financial related securities with bank equities index down nearly 13% while credit widened to levels only briefly exceeded in the 2020 Q1 sell off and are now pricing in considerable economic downside.   With this turbulence as backdrop the fund’s A shares dropped 6.09% with credit accounting for -585bps of the gross performance and equities -19bps.

In looking forward we see that credit securities have increasingly become divorced from underlying fundamentals.  On the one hand, rate markets are adjusting downward expectations of future hikes, especially in Europe, as signs of slowdown emerge.  What effect this has on inflation remains to be seen and there are too many factors driving prices to already declare victory.  But it remains a good bet that the equilibrium level of rates will be lower than originally thought several months ago.  We therefore believe there is excess risk premium now priced into markets – credit in particular – and future returns will reflect that.  But volatility and illiquidity will remain as challenges, and it is difficult to say that the market has reached an equilibrium of buyers and sellers.  Caution remains an overriding principal.