Commentary Categories: ALTERNATIVE GROWTH

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.

As was largely the case for 2022 as a whole, investors looked to inflation and its potential impact on central bank policy to guide sentiment.

Pleasingly, inflation numbers did moderate once more, with US headline falling to 7.1%. However, central bank rhetoric remained hawkish meaning there was some tempering of the buoyant mood that had characterised the fourth quarter to December.

There was idiosyncratic optimism in China as the continuation of the relaxation of ‘zero-Covid’ policy allowed for some further recovery in their ailing equity markets, including in Hong Kong.

Elsewhere, even Japan finally jumped onto the tightening bandwagon as they adjusted Yield Curve Control (YCC) by widening the target band to 50bps on the 10 year yield target of 0%.

The Fund increased by 0.3% to end the year up 1.0%.

As one might expect, given the softer inflation print, the Fund’s rates volatility strategies were relatively muted.

However, as central banks doubled down on hawkish rhetoric, credit spreads did widen, to the benefit of the Fund’s credit volatility strategies.

Elsewhere, the Fund’s FX value strategies, which had suffered at the hands of the dollar for most of the year, continued their recovery. Gold intraday again struggled on non-normal gold price action.

As we head into 2023, there are three scenarios that could play out for investors to consider:

1.The Fed have tightened the perfect amount; soft landing.

2.The Fed have tightened too much; hard landing.

3.The Fed have not tightened enough; higher for longer.

In Q4 markets priced in an increasing likelihood of outcome 1. Whilst this is possible, and clearly is what we all hope for, on the balance of probabilities it is unlikely, particularly when one considers that they have never managed it in any previous rate rise cycle.

In scenario 2, fixed income is likely to have its time once more, and provide some diversification to the equity content in portfolios that is likely to struggle in all three of these scenarios.

However, given that the stickier core components of inflation remain stubborn, the world is de-globalising at an alarming rate, the world’s second biggest and most commodity hungry economy is reopening, and unemployment remains floored with labour markets tight, a significant probability must be assigned to the chance that inflation has not yet been defeated. Scenario 3 would likely see the same dynamics as in 2022 of bonds and equities selling off together once more.

Liquid alternatives should perform relatively well in all three scenarios, the same cannot be said for much else.