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Navigating the Five Macro Regimes of 2022

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London (HedgeNordic) – Jupiter Strategic Absolute Return Bond Fund (SARB) is a flexible liquid global macro strategy taking long and short positions in sovereign bonds, interest rates, currencies and credit with most exposure in developed markets and an average investment grade credit rating. Non-investment grade exposure is predominantly emerging market sovereigns and some corporate or financial credit in developed markets. “We profit from price moves based on macro, and take low default risk,” says Mark Nash, one of three portfolio managers.

The strategy aims for “all weather” returns and has delivered positive performance in 96% of rolling 12-month periods. Through a full cycle the target absolute return on the fund is cash +4% with volatility of 4% and a Sharpe ratio of one. Since inception the strategy has met its alpha target but undershot on volatility and overshot on the Sharpe, while maintaining a slightly negative correlation to global bonds and equities. Some investors especially in Asia use leverage to dial up risk.

The risk target was low for much of 2022 due to the fluid macro backdrop but has started to pick up as the managers build somewhat higher conviction in the latest macro regime, while keeping a close eye on market action and maintaining strict risk management: “We are very flexible with our views because the world is complicated. We quite often change the strategy altogether. We are close to market price action and use momentum signals to help decide if our top down macro view is right. We control drawdowns and defend the portfolio if we are wrong,” says Nash, who argues that having only three portfolio managers allows SARB to make swifter decisions than some larger teams that follow slower processes. SARB portfolio construction is assisted by a specialist who translates the broad thematic model portfolio views into positions that carefully optimise for volatility and risk budgets, which helps to hit the Sharpe ratio target.

SARB’s top down view since 2000 has been that Covid shifted policymakers towards a more reflationary and well-rounded global economy, supported by deleveraged consumers, and corporates spending more to help constrained supply catch up with robust demand.

Yet within this big picture there can be multiple chapters in just one Gregorian calendar year.

Five Regimes

SARB started 2022 with a view that Covid headwinds were waning due to a less virulent Omicron strain, leading to reflation and higher growth. “This led to short core bonds, yield curve steepeners, long inflation and selected emerging market bonds, and a small short in corporate bonds, for the first two months of the year,” says Nash.

After Russia invaded Ukraine, pushing up food and energy prices, the regime changed to one of bad inflation and risk off with more rate hikes and slower growth. “The positioning increased short corporate bonds; maintained short core bonds in Treasuries, bonds and gilts as the bond rally did not make sense, and kept longs in EM resource producers. This phase lasted about three months,” says Nash.

By May, energy prices in fiat currency were weakening, and the real yield curve started to flatten and then invert. “Higher yields made it worthwhile own bonds and go tactically long risk over the summer, even if we were skeptical about the “everything rally,” continues Nash.

By the end of the summer, US economic data was improving with higher real incomes, and European governments essentially wrote blank cheques to subsidise energy, boosting borrowing needs. “This shifted the focus back to inflation, and SARB reversed to short bonds again,” points out Nash.

By October a constellation of factors suggested a move from fiscal instability and bad inflation to higher growth and disinflation created potential for a “goldilocks” soft landing.

Soft Landing Aided by Four Factors

In the fourth quarter, the fund identified a fifth regime and has made a reasonably sudden shift from net short to net long in developed market interest rates and corporate credit as well as some contingent convertibles issued by banks. Price action was one driver: “price moves in the risk off, long dollar, short bonds trade were running aground even with bad CPI numbers,” recalls Nash.

Fundamentally, the Team Have Identified Four Constructive Factors

Nash argues that some central banks have suggested that they will tolerate inflation somewhat above their official 2% targets, in order to avoid recession. This somewhat dampens the most hawkish rate hike scenarios.

The US CPI is improving with some goods price disinflation. There might be some one-offs in medical services, but US rents have surprised on the downside even during the busiest moving period between August and October. Energy prices are coming down in the US and lower natural gas prices are particularly helpful in Europe.

Fiscal policy is becoming more disciplined as the energy subsidies announced over the summer are scaled back, and will cost less with lower gas price. Public spending overall looks less alarming for bond investors.

Supply chains are improving with ISM delivery times coming down, partly thanks to China reopening, and this helps to reduce new and used car prices. China reopening, reducing mass testing and quarantine requirements, and allowing more diplomatic travel also helps to push down the US dollar and improve risk appetite.

The one missing ingredient is more moderate wage inflation. The labour market remains tight, especially in leisure and travel sectors, which could lead to some persistent wage price inflation.

Energy Exporters and Importers

Yet the portfolio is also positioned to profit from some inflationary trends, directly through owning inflation-linked bonds issued by countries such as Japan and indirectly through commodity and resource producers and exporters, such as Brazil, Mexico and South Africa in EM, which are owned on an unhedged basis, giving exposure to both local currency yields and potential currency appreciation. “Some emerging markets also have a better inflation outlook as they have more labour supply and a larger share of food and oil in their inflation baskets. They were also earlier movers in hiking rates than developed countries,” explains Nash.

Another angle on this trade is to buy energy importers that have blown out to very stressed yields, such as sovereigns in Poland, Hungary and Greece. “lower energy prices and fuller storage tanks should help sentiment,” says Nash.

If energy prices start to recover (possibly due to one or more of China reopening, OPEC cuts or geopolitics in Russia or the Middle East) this positioning could be tempered perhaps with a short in German bunds.

Continuing Short Positions

Though the portfolio is broadly long of duration and credit the outlook is not universally benign and there are still some shorts, which both act as hedges for the key long themes and could be attractive absolute wagers.

“The worst risk asset is US credit. The perception of US assets being a safe haven due to the dollar and energy security is now changing. We are short of US high yield credit and short the belly of the US rates curve. US equity valuation seem high and investors are shifting from growth to value leading to better risk/reward in Europe and China, which are starting for a lower base,” says Nash.

High Rates for Longer

Nash expects that consensus forward curve terminal US rates of 5.25% are realistic, but is skeptical about the timing of rate cuts priced into the curve. He expects that rates will peak at a high plateau for longer than the market consensus, due to a robust economy. “Excess demand will make it very hard for central banks to start cutting with strong consumers and corporates investing in robots to replace labour. In addition the bond rally is partly a technical short covering move”. He is also of the opinion that the inverted yield curve need not predict a (potentially disinflationary) recession in the new economic environment: “It simply reflects high spot inflation”.

Nash expects that central banks want to strike a happy medium by avoiding steep rate rises that could cause a severe recession and unemployment, while also avoiding the 1970s resurgence of inflation that came from cutting rates prematurely. This leads to a short in belly maturity Treasuries.

Short Japan and UK

SARB expect that Japan will eventually need to tighten in 2023 as the Japanese economy has almost fully reopened and inflation is increasing. SARB is short of nominal Japan bonds as well as owning Japanese inflation linked bonds.

A short in the UK is partly based on the view that the UK trade deficit will force it to pay more to compete for capital.

The above views were accurate in early December 2022 when HedgeNordic interviewed Mark Nash, but of course if another regime emerges soon, many of these positions could be swiftly cut and reversed, and fresh trades could be implemented, as they were in 2022. In addition, the ideas discussed here are broad thematic positioning from model portfolio updates, overlooking nuances such as exact maturities and yield curve trades.

ESG Update

ESG is probably most sophisticated and extensive for long only equity strategies, but it does have an evolving role in macro strategies.

SARB is currently disclosing under SFDR 6 but will be transitioning to SFDR 8 in 2023.

The ESG policies including ranking and screening sovereigns on criteria including carbon policy, governance and human rights.

“Egypt is one example of a lower ranked sovereign which led to a divestment in late 2021. Elsewhere in the Middle East, many nations like the UAE benefit from strong governance structures, although often score poorly on freedom of speech and broader human rights. UAE will need to accelerate their transition away from fossil fuels if they are to impress when they host COP28 next year,” says co-portfolio manager James Novotny.

On the corporate side, ESG is less relevant to SARB because it generally does not invest in single name corporate issues (besides some CoCos).

ESG credit indices are not currently used partly due to concerns about lack of liquidity, which is especially important given the liquid trading approach. In addition, the methodologies used to construct some indices can be rather simplistic and do not always align well with Jupiter’s own perspectives on topics such as energy transition.

 

This article features in HedgeNordic’s “ESG & Alternative Investments” publication.

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