4 min read 21 Nov 22
The central banks were wrong, in my view, to wait so long before reversing their accommodative monetary policies, but we are confident that they will be able to eliminate inflation. We are investing in corporate bonds given the current yields on offer.
If I were to sum up my job in a few words, I would say it consists in spotting opportunities within market distortions or anomalies that have been created as a result of a mistaken economic consensus or due to technical reasons. And if I were to describe it today as applied to my scope of activity, which covers the bond market and corporate debt, I would say that there are many such opportunities out there to grasp, probably more than there have ever been in the past 10 years.
So, after having applied the utmost caution for some time, we have now increased the duration of our portfolio to the extent that it has reached neutrality with our benchmark index, i.e. its highest level in a decade. We are firmly convinced that monetary policies will prove effective and that central banks will be able to overcome inflation.
How widespread is inflation? And where does it come from? We can begin by noting that it is universal in nature, even though today’s rising prices are affecting developed countries more than others. And it stems from the previous round of monetary stimulus, which already seems to date back to another era but actually occurred just two and a half years ago when COVID appeared.
Economic forecasts at the time pointed to V, W or even L-shaped scenarios, whereas we have actually experienced a T-shaped recovery with economic activity bouncing back immediately and then rapidly returning to normal. Yet in their belief that inflation was gone forever, central banks kept their monetary policies accommodative even when this was no longer necessary. In my opinion, that was a historical mistake!
The good news is that if central banks are able to create inflation, they are equally capable of eliminating it by adopting restrictive policies, raising interest rates and reducing the amount of money available. All economic research sees inflation as being a purely monetary phenomenon.
But investors will need to have a little patience. On average, it takes 18 months for monetary tightening to produce its full effects. This time, rising prices have also been exacerbated by the war in Ukraine and by the currency movements it has triggered.
The bond market looks highly attractive, in my view, bearing in mind that inflation should move back towards the 2% level targeted by central banks and yields have recently skyrocketed.
It went without saying that bonds offered little upside potential when their yields were negative, whereas it now makes sense to hold bonds on the basis of their risk/reward profile. And I am talking here about conventional bonds. Index-linked bonds seem to offer less value at current breakeven inflation levels, especially as they are penalised by lower liquidity and therefore higher volatility.
To us, the corporate bond market inspires confidence as bonds are currently pricing in a severe recession, which would take a heavy toll on company profits: this is a scenario we do not adhere to. Employment is an excellent barometer of the state of the economy, and we believe it is in better shape than is generally thought. Market observers are tending to ignore the good news, both in the USA and in Europe.
Our portfolio is overweight investment grade corporate bonds but also high yield bonds. The yields on offer offset any credit risk, in our opinion. Companies carry relatively little debt and so we believe they should be able to weather the upcoming interest rate hikes. There will be some defaults, of course, but we think these will be fewer than the market expects. When an already sluggish economy continues to contract, the defaults pile up. But far less damage is done when the slowdown hits a strong economy. In other words, it is easier to handle a drop in temperature from 30 to 25 degrees than from 5 degrees to subzero.
The value of a fund's assets will go down as well as up. This will cause the value of your investment to fall as well as rise and you may get back less than you originally invested. The views expressed in this document should not be taken as a recommendation, advice or forecast. Whenever performance is mentioned, past performance is not a guide to future performance.