Commentary Categories: ALTERNATIVE GROWTH

The first quarter of 2023 will in time be remembered as an extraordinary one.

When one looks at the end result, it has been a welcome respite for risk assets as well as the 60/40 portfolio after a difficult 2022. Global equities have annualised at 35% and global bonds 14%.

However, the journey of travel has been, as is the norm now with the amount of leverage in the system, anything but smooth to get there.

As we entered the year, headline inflation had been falling and data improving, causing markets to begin to price in a ‘no landing’ scenario and a return to loose monetary conditions much sooner than was previously forecast, to the benefit of risk assets across the board.

February saw some reversal as the ‘headwind’ of strong data surprises as well as a reacceleration in core inflation numbers forced investors to once more reassess both the terminal rate and more importantly how long rates may remain elevated for; the market was back to the 2022 scenario of bonds and equities struggling simultaneously.

The prospect of rates staying higher for longer caused some cracks to appear in the banking sector in March, albeit consigned to smaller banks that had a duration mismanagement / no management issue coupled with a concentration of potentially flighty VC fund deposits. In mid-March the market had a significant wobble followed by the extremely unusual scenario in which the bond market was pricing in a banking crisis whilst equity and credit were unmoved and latterly buoyant; the Fed put is back it would seem.

The Fund returned -0.3% for the month and 0.3% for the quarter.

Once more the Fund, in the eye of the storm in March, showed its defensive qualities as it began on its usual upward convex trajectory as the mini-banking crisis unfolded.

The strategies that performed particularly well during that period were the Fund’s protection strategies, namely the long CDS positions and put spreads. As the month wore on, and the market embarked on a swift recovery and credit spreads collapsed, those gains were given back.

The main detractors, as one might imagine, given that the bond market has priced in a crisis and the associated cuts to rates starting as soon as June, were the rates volatility strategies.

We are now in the extraordinary position in which, in spite of rising geopolitical tensions, core inflation that remains stubbornly elevated, worsening data, and cracks appearing in the fabric of the financial system, global equities are running at an annualised 35% whilst the bond market is pricing in a recession; one of them must be wrong.

The market, so used to intervention at the first sign of trouble, blindly assumes that liquidity will be added as and when required in order  to keep asset prices buoyant; animal spirits are the only explanation for the current rally we are seeing. The Fed may abandon their inflation mandate. It would be a policy error, but would not be the first. However, they themselves are adamant they will not, and the market once more may be forced to grapple with this reality. Either way, equities and bonds remain correlated, predicated on central bank policy, and investors absolutely must maintain some form of diversification in case the liquidity deluge that is priced in is not in fact set to continue, never mind if there is a hard landing that awaits.

What a difference a month makes.

After January’s optimism, investors were forced to take stock as the positive data points continued, but this time accompanied by a reacceleration of core inflation numbers. This led to a reassessment as to where the terminal rate lies and how long rates are likely to be elevated in the Fed’s continued fight against inflation.

In terms of the three scenarios for the year:

1.The Federal Reserve have tightened the perfect amount and orchestrated a soft landing

2.They have tightened too much already and a hard landing lies ahead

3.They have not tightened enough and rates will be ‘higher for longer’

Having more or less priced in 1, the market was forced to recalibrate and apply a higher probability to scenario 3. Investors have thus far this year seemed content to follow the data in ascribing very little probability to scenario 2, they have been less willing to use that same data to meaningfully increase the probability of scenario 3.

The Fund increased by 1.2% during the month.

After the collapse in rates volatility at the start of the year, with higher prices came higher volatility, to the benefit of the Fund’s long rates volatility strategies.

Elsewhere, the majority of the Fund’s other exposures also provided for some positive return. The notable outlier was the Gold Intraday strategy, which is net long gold and suffered as rates made their way back up.

Two new positions have been added to the protection portfolio in the form of two put spreads on the S&P 500, taking advantage of the low volatility seen after the years initial rally.

The buoyancy of January turned out to be short lived as inflation’s downward trajectory paused, and in core numbers even reversed slightly. February brought back memories of 2022 as both equities and bonds sold off simultaneously. It is in these conditions that bonds will continue to fail to fulfil their role as a diversifier in portfolios. The market still misprices the likelihood of inflation proving more stubborn and central bank’s hands being tied with regards to policy.  

For the first time in many years central banks have replenished their policy quiver with the arrows of rate cuts when necessary. However, the idea that they would use those arrows before either it is completely necessary or the battle against inflation has been truly won is fanciful. Never before have the Fed managed to orchestrate a soft landing; this could be the first time, but history tells us that they tend to raise rates until something breaks in the economy. Here is to hoping that this time is different; it rarely is. In the meantime, the portfolio is well positioned to provide true diversification and has during its life tended to prefer periods of heightened stress for traditional asset classes

Recession, what recession?!

Risk assets have enjoyed a stellar start to the year as price increases continued to slow in December whereas data in January turned more positive.

There are only three possible outcomes from here:

1.The Federal Reserve have tightened the perfect amount and orchestrated a soft landing

2.They have tightened too much already and a hard landing lies ahead

3.They have not tightened enough and rates will be ‘higher for longer’

Price action over the past months can be attributed to investors’ views as too which of these scenarios is most likely. It is clear that the overwhelming consensus is that, for the first time in their history, the Federal Reserve have managed to orchestrate a soft landing, to the extent that opinion has begun to even shift from shallow recession to no recession at all.

Equity and bond markets have enjoyed significant rallies this year as a result, whilst implied volatilities have collapsed.

The Fund decreased by 0.6% in January.

Unsurprisingly, given the collapse in implied rates volatility, the rates volatility strategies were the biggest detractors. The market now not only prices a pause, but a pivot in the second half of the year. Levels of implied volatility have fallen back to where they were before the invasion of Ukraine, and given the backdrop of strong demand, a Chinese reopening that is beginning in earnest, robust employment, and continued deglobalisation, rates volatility looks mispriced once more. Added to this, the premia itself has increased due to the steeper term structure after the falls at the back end of the curve.

The other significant detractor were the CDS positions. The Fund, in its protection bucket, holds significant exposure to CDS. The buoyancy in markets and heavy falls in volatility have also been accompanied by a significant tightening of credit spreads to the extent that they also are back to the levels they were at the beginning of last year.

The Fund’s commodity and FX strategies provided some positive performance over the month. In particular, the commodity strategies are set to benefit from any demand weakness brought on if conditions worsen throughout the year.

The market is increasingly confident that the Federal reserve have managed to orchestrate a soft landing. Whilst this might be the case, purely on the balance of probabilities it is less likely than the other outcomes of a hard landing or the need for higher rates for longer. Investors should note that in all previous rate rise cycles, soft landing type conditions have been experienced at some point, after all, you need to at least pass through those types of conditions before heading elsewhere. Let us hope we have reached our final destination.