For all of 2022, we have focused on tighter monetary policy, discussing the dilemma faced by central banks (in ‘Czech Mate’) and their subsequent decision to prioritize the war on inflation (in ‘The Inflation Game’). As we peer into 2023, the themes have not only not changed – they’ve intensified. Consensus market hopes that the Fed would end their tightening campaign this autumn were squashed by Fed Chairman Powell at Jackson Hole.
Hopes that the ECB would continue their “gradual shift” were overturned abruptly by Christine Lagarde’s hawkish turn in September. Hopes that inflation might moderate were confounded by an elevated August US CPI release. Hopes of a gradual cooling in labor markets presaging a soft landing that many market participants want to see look wildly optimistic: every single one of the last 16 monthly non-farm payrolls prints has been above 290,000, with the last 3-month average at nearly 400,000.
The higher the readings on inflation, wages or jobs, the more central banks will need to jack up rates to recession-inducing levels. Weaker data would suggest a trend towards recession; stronger data, a need for more rate hikes. In a kind of heads-I-win-tails-you-lose central bank environment, until the war on inflation is won, the chance of a soft landing looks slim.
Tighter monetary policy of course has more than just economic consequences. For markets, moving rates into restrictive territory – at 75 bps clips, even in the Eurozone – means a tightening of financial conditions. Meanwhile quantitative tightening is set to accelerate, raising market volatility further. So how to position?
In yield curves, the macroeconomic and policy backdrop means front-end yields remain under upward pressure in the near term. The EUR yield curve has now started to flatten aggressively, a move we have been expecting all year. The EUR 2s10s swaps curve is now inverted, following the GBP SONIA curve, Korea and US Treasuries in a broadening wave of global curve flattening first presaged in Czechia right back in Q1.
Yet in time, these moves towards flat and inverted territory are likely to reach an inflection point. Even in the four recessions of the 1968-82 era, bond yields fell materially. By March 2023, on current pricing, year-on-year oil price changes are set to be negative. Broader commodity market moves are also softening: copper, lumber and various cyclical raw materials have already fallen heavily year to date as the growth outlook has darkened.
Headline inflation is already moderating in the US. But the rise in various core measures (including rents and wages) means central bank tightening is inked in for the near term.
As we head towards what looks like a market turn in rates, and the prospects for much better bond returns during recession, we consider three tests for duration. For portfolio construction, we continue to draw a distinction between the merits of yield curve versus duration strategies.
As we have mentioned before, to be profitable with large-duration trades, you have to call two things right: the cyclical outlook for growth, and the secular outlook for inflation. Yet for yield curves, the cyclical outlook does most of the job (because inflation premia exist across much of the yield curve and the secular level of rates and inflation is in any case somewhat embedded in official rates). We think there is much more visibility in the data on the cyclical growth outlook, than in the secular inflation outlook.
On the latter, questions remain unanswered: will wage rises lead to second-round effects (see the recent Dutch railway worker settlement for a 9.25% pay rise) or will demand destruction see sharp falls in prices (see the 30% fall in oil prices since March)? Which will dominate? Taking large bets on this unsettled debate looks an inappropriate way to manage client funds in our view, because the risk is still somewhat symmetrical. 2022 is already the worst year for fixed income total returns since 1788 by some counts.
Yet betting on a continuation of duration trends – trying to chase momentum for higher yields – looks risky. First, the twelve weeks since our last quarterly outlook have seen huge about-turns in rates: Schatz yields for example have moved from 1.20% down to 0.20% to back over 1.50%. But second, the extensive analysis we have undertaken for our latest Global Macro Quarterly meetings shows we should expect a turn – just not quite yet.
On the other hand, using historical frameworks to identify when yield curves have over-inverted to the point where the curve outlook is asymmetrical, remains a much better risk-reward approach in our view.
Yield curves are cyclically mean-reverting over time, be that in high inflation regimes (for example 1965-82), periods of inflation moderation (1982 to mid-1990s), or low inflation (mid-1990s to 2020). That means that excessively inverted yield curves are eventually likely to dis-invert and re-steepen. We therefore recommend using deep inversions in the US Treasury curve to scale into steepening positions – a trade that we think should make 100-150 bps of alpha on its own into H1 2023. Against that, we see some residual room for EUR curves to flatten.
As we said last quarter, we do not yet think recession is priced into high yield spreads. Since then, credit markets attempted a summer rally in July and early August, on the hope of a dovish Fed this autumn. That looked misplaced to us and we have used the rally to lighten up. Since mid-August, spreads have started to widen.
For sure, credit markets have cheapened this year – but only from their most expensive levels post-2008. This leaves the USD BBB OAS, the EUR BBB ASW and spreads for high yield markets sitting at (or even tighter than) their averages for the past quarter of a century. If history is any guide, an average spread is not the right level of compensation for recession.
Looking ahead, hopes for a turnaround look over-optimistic to us, given the monetary policy outlook, the reality of what turns credit bear markets around, and the relatively limited scope we see for game-changing fiscal policy. Only EUR swap spreads trade at recessionary or crisis levels.
Then there is sequencing. In the past 50 years, every single recessionary peak in credit spreads has been preceded by a peak in government bond yields. Usually by many months or even years. We do not believe this time will be different. We expect to see twin peaks: first in government bond yields, and then in credit spreads. The trouble is, the gap may be several months – and possibly many basis points – later.
The contents of this document have not been reviewed by the Securities and Futures Commission ("SFC") in Hong Kong. If you are in any doubt about any of the contents of this document, you should obtain independent professional advice. This document has been distributed by Robeco Hong Kong Limited (‘Robeco’). Robeco is regulated by the SFC in Hong Kong.
This document has been prepared on a confidential basis solely for the recipient and is for information purposes only. Any reproduction or distribution of this documentation, in whole or in part, or the disclosure of its contents, without the prior written consent of Robeco, is prohibited. By accepting this documentation, the recipient agrees to the foregoing
This document is intended to provide the reader with information on Robeco’s specific capabilities, but does not constitute a recommendation to buy or sell certain securities or investment products. Investment decisions should only be based on the relevant prospectus and on thorough financial, fiscal and legal advice. Please refer to the relevant offering documents for details including the risk factors before making any investment decisions.
The contents of this document are based upon sources of information believed to be reliable. This document is not intended for distribution to or use by any person or entity in any jurisdiction or country where such distribution or use would be contrary to local law or regulation.
Investment Involves risks. Historical returns are provided for illustrative purposes only and do not necessarily reflect Robeco’s expectations for the future. The value of your investments may fluctuate. Past performance is no indication of current or future performance.
Please read this information carefully.
This website is prepared and issued by Robeco Hong Kong Limited ("Robeco"), which is a corporation licensed by the Securities and Futures Commission in Hong Kong to engage in Type 1 (dealing in securities); Type 4 (advising in securities) and Type 9 (asset management) regulated activities. The Company does not hold client assets and is subject to the licensing condition that it shall seek the SFC’s prior approval before extending services at retail level. This website has not been reviewed by the Securities and Futures Commission or any regulatory authority in Hong Kong.
2. Important risk disclosures
2. Important risk disclosures Robeco Capital Growth Funds (“the Funds”) are distinguished by their respective specific investment policies or any other specific features. Please read carefully for the risks of the Funds:
3. Local legal and sales restrictions
The information contained in the Website is being provided for information purposes.
Neither information nor any opinion expressed on the Website constitutes a solicitation, an offer or a recommendation to buy, sell or dispose of any investment, to engage in any other transaction or to provide any investment advice or service. The information contained in the Website does not constitute investment advice or a recommendation and was prepared without regard to the specific objectives, financial situation or needs of any particular person who may receive it. An investment in a Robeco product should only be made after reading the related legal documents such as management regulations, prospectuses, most recent annual and semi-annual reports, which can be all be obtained free of charge at www.robeco.com/hk/en and at the Robeco Hong Kong office.
4. Use of the Website
The information is based on certain assumptions, information and conditions applicable at a certain time and may be subject to change at any time without notice. Robeco aims to provide accurate, complete and up-to-date information, obtained from sources of information believed to be reliable. Persons accessing the Website are responsible for their choice and use of the information.
5. Investment performance
No assurance can be given that the investment objective of any investment products will be achieved. No representation or promise as to the performance of any investment products or the return on an investment is made. The value of your investments may fluctuate. The value of the assets of Robeco investment products may also fluctuate as a result of the investment policy and/or the developments on the financial markets. Results obtained in the past are no guarantee for the future. Past performance, projection, or forecast included in this Website should not be taken as an indication or guarantee of future performance, and no representation or warranty, express or implied, is made regarding future performance. Fund performance figures are based on the month-end trading prices and are calculated on a total return basis with dividends reinvested. Return figures versus the benchmark show the investment management result before management and/or performance fees; the fund returns are with dividends reinvested and based on net asset values with prices and exchange rates of the valuation moment of the benchmark.
Investments involve risks. Past performance is not a guide to future performance. Potential investors should read the terms and conditions contained in the relevant offering documents and in particular the investment policies and the risk factors before any investment decision is made. Investors should ensure they fully understand the risks associated with the fund and should also consider their own investment objective and risk tolerance level. Investors are reminded that the value and income (if any) from shares of the fund may be volatile and could change substantially within a short period of time, and investors may not get back the amount they have invested in the fund. If in doubt, please seek independent financial and professional advice.
6. Third party websites
This website includes material from third parties or links to websites maintained by third parties some of which is supplied by companies that are not affiliated to Robeco. Following links to any other off-site pages or websites of third parties shall be at the own risk of the person following such link. Robeco has not reviewed any of the websites linked to or referred to by the Website and does not endorse or accept any responsibility for their content nor the products, services or other items offered through them. Robeco shall have no liability for any losses or damages arising from the use of or reliance on the information contained on websites of third parties, including, without limitation, any loss of profit or any other direct or indirect damage. Third party off-site pages or websites are provided for informational purposes only.
7. Limitation of liability
Robeco as well as (possible) other suppliers of information to the Website accept no responsibility for the contents of the Website or the information or recommendations contained herein, which moreover may be changed without notice.
Robeco assumes no responsibility for ensuring, and makes no warranty, that the functioning of the Website will be uninterrupted or error-free. Robeco assumes no responsibility for the consequences of e-mail messages regarding a Robeco (transaction) service, which either cannot be received or sent, are damaged, received or sent incorrectly, or not received or sent on time.
Neither will Robeco be liable for any loss or damage that may result from access to and use of the Website.
8. Intellectual property
All copyrights, patents, intellectual and other property, and licenses regarding the information on the Website are held and obtained by Robeco. These rights will not be passed to persons accessing this information.
10. Applicable law
The Website shall be governed by and construed in accordance with the laws of Hong Kong. All disputes arising out of or in connection with the Website shall be submitted to the exclusive jurisdiction of the courts of Hong Kong.