Q1 2021: "The Great Escape"

“Colin's not a blind man as long as he's with me. And he's going with me!!”

Hendley “The Scrounger” (James Garner), The Great Escape, film directed by John Sturges, The Mirisch Company, 1963

Full Report in pdf on the link below

What has happened?

2021 started full of promise as the COVID-19 vaccine programme in the West crucially moved up a gear, finally bringing hope of a return to normality. Both global infection and mortality rates also finally started to fall after Q4’s increase at the hand of new variants. Unfortunately, as optimism fuelled a shift in focus from virus containment to vaccine rollout, the “Great Escape” plan hit its first roadblocks highlighting how disparate the global recovery would be. In the West, both the UK and US led the way in vaccine rollouts while continental Europe suffered from a third wave, further lockdowns, and a bungled start to its vaccine campaign, having spent more time criticising vaccine brands and the first shot vs. double shot approaches rather than ramping up distribution.The Far East continued to contain the virus and keep both infection and mortality rates low. (Please see page 10 of full report for more detail).

The quarter began with the storming of the US Capitol by President Trump’s far-right supporters, which ironically seemed to cement a more left-leaning Biden cabinet than many Democrat centrists had expected. In its earliest days, the Biden Administration introduced one of the largest big-government interventions ever seen in the form of a USD 2trn stimulus package and the announcement of an additional USD 2.3trn infrastructure package (pending approval) to reignite the US economy and create jobs. Against the backdrop of these bazooka shots, Q1 US macroeconomic data painted an improving picture, with more to come in Q2: GDP continued to grow (Q1 2021: 6.4% GDP annualised QoQ), consumer confidence was stable (yet to reflect March’s stimulus package as macro data has a lag), and unemployment fell (albeit at a slower pace: 7.8% as of Q3 2020, 6.7% as of Q4 2020, and 6.0% as of Q1 2021). Meanwhile, the Eurozone continued its slow, patchy recovery: unemployment dropped to Q4 2018 levels (8.3%) and consumer confidence improved, but previous trends in retail sales and new home builds were not great. Turning to the East, Asia continued to be the rising sun on the global stage and is uniquely placed to benefit from both domestic and global recovery, led by China, which clearly (and paradoxically) is the one major region to have successfully navigated the “Great Escape”!

As the world continued its recovery, equities continued to roar and posted high single/low double-digit returns by mid-February. Macroeconomic data typically looks backward while markets look forward - the chart to the right shows the gap between future expectations and current reality. There is no doubt that this “hope gap” can persist, but it does justify a cautionary approach to positioning. The equity market’s day of reckoning came in mid-February when the rate market suddenly woke up from its slumber as participants started to get excited about stimulus and began speculating about inflation. This translated into hefty losses for the much lauded “safe-haven” assets while 10Y US treasury yieldsmoved +75 bps. This move also especially hurt long-duration stocks (clearly precarious, not being supported by current economic data), which turned out mainly to be the growth stock darlings that had done so well since the pandemic started. However, these huge shifts did not do enough to scare off investors. With central banks continuing to play very accommodative tunes and fiscal stimulus subsidising retail investors (in the US at least), it was not entirely surprising to see most risk metrics actually fall this quarter: the VIX index ended Q1 <20 and credit spreads returned back to 2019 averages.

Our strategy performance

In the context of Q1’s macro and market environment, our Tyrus Capital Global Convertible strategy delivered +1.7% in Q1 2021 (SI USD acc. Class), while keeping 90-day volatility low at 5.1%. We outperformed traditional fixed income (investment grade bonds: -3.2%) in the face of the yield curve shift as vanilla convertibles cushioned the rate movement much more due to their lower modified duration. In fact, rising rates benefited the asset class as they stimulated record levels of primary issuance, delivering an asset class with even more attractive valuations and lower risk (liquidity is the main risk) this quarter-end than Q4 2020

Our view

Main focus: Inflation. We are not too worried about inflation as our model accounts for some transitory price pressure and we do not believe we will reach the uncontrolled state of spiralling inflation prophesised by some. The employment market is not close to being tight, the impulse is mostly fiscal and short-term in nature, and (most importantly), long-term demographic and energy/productivity trends are still very much deflationary. Also remember that we are living in debt-laden economies: if we genuinely achieve more permanent inflation, would it be such a horrible prospect? So, if it is not uncontrolled inflation that is keeping us on our toes, what is? As Ray Dalio calls it, a return to the “great sag” era (a tepid growth environment which persistently suppresses inflation) worries us most.

All the rest: Given our views on inflation, and now faced with a more positive global economic outlook, particularly from a GDP perspective, we are most focused on targeting specific growth and policy upside beneficiaries (e.g., countries, sectors, individual companies, etc.) rather than focusing on defending a threat of runaway inflation. Our key thoughts and risks are as follows:

It is clear to us that economic recovery and its associated risks will vary significantly across the globe. In the US, we think the macro surprise is likely to be on the upside given a good vaccine rollout to date, a stimulus package with effects yet to be felt, and further potential momentum from an infrastructure plan (approval pending) to come (page 14). While certain sectors (e.g., travel, leisure, and infrastructure) will benefit specifically overall, stock market momentum is less clear given stretched valuations and the threat of dramatic tax hikes to come (which has so far been ignored). Turning to Europe (page 24), we expect the UK to successfully continue to roll out its vaccination programme and look forward to the reopening of its economy, with any GDP catch-up of course closely tied to the lifting of lockdown restrictions. However, we expect the timing and impact of any recovery to differ within the rest of Europe, with a recovery likely reliant on a country’s GDP profile (e.g. tourism vs. manufacturing) and where and how quickly ECB stimulus trickles down into countries. Despite nuances, we do see macro data for the region continuing to slowly improve overall. With Asia being both a paragon of growth and an attractively priced region, we think it will outperform (net of any potential short-term rebound positioning away from the region) and is therefore our biggest focus for the long-term (page 19). We acknowledge that geopolitical confrontation is concerning (e.g., Taiwan), but we feel that this will play out over a longer-term time horizon. From a fixed income perspective and despite our belief that long-term rates are in a bearish mega-trend, we are still sceptical about longer duration bonds. Fixed income data shows that high yield (“HY”) bonds outperformed their investment grade peers (“IG”) and that Europe outperformed the US, but this is a result of rate sensitivity and not fundamentals (page 29 in full report).

How are we positioned?

Taking the above foundational views into account, the question turns to how these events effect our five investment themes, portfolio positioning, and trading strategy looking forward:

Where does this leave convertibles?

Typically, one of the most compelling arguments for investing in convertible bonds is their asymmetry of returns derived from equity. Multi-asset allocators can leverage their lower risk level to improve their portfolio efficiency. Both of these strategic benefits particularly resonate when equity valuations are as stretched as they are now. What is not discussed so often is thedefensive nature of convertible bonds in the context of rate and/or spread changes. Their lower sensitivity to rate moves (or credit spread assumptions) not only offers longer-term strategic protection from fixed income volatility (which looks more likely going forward) but also gives them a tactical argument: the recent yield curve shift and resulting shock to bond prices (see right hand chart) prompts a discussion around whether those alternatives provide a better risk-reward profile in the short term than traditional fixed income allocations (be it IG or HY).

Accordingly, we feel it is important to flag the advantages of low-duration, low-volatility convertible strategies like the Tyrus Capital Global Convertible. Following efficient frontier portfolio theory and in the context of limited prospects for further tightening, investors could replace some traditional HY exposure, lowering the duration risk while also improving the asset quality and liquidity. This logic could be pushed even towards lower IG debt given our BBB rating. This obviously does not change the long-term strategic case for the asset class, especially given choppy path to the year-end, but tactically this surge in fixed income volatility creates a clear window to switch towards an exposure to much cheaper equity volatility on the back of very tight spreads.

Best wishes, D. Regnier