Q2 2022: "The Dark Knight"

Madness, as you know, is a lot like gravity. All it takes is a little push.” The Joker (Heath Ledger), The Dark Knight, movie by Christopher Nolan, Warner Bros. Pictures, 2008?

What has happened?

Fear. Madness. Irrational exuberance.

All words used to describe what has been another challenging quarter for investors. The macroeconomic divide between the West and the East continued as both faced a different set of challenges in Q2 2022. In the West, the stagflation cycle was in full speed as inflation reached new highs (May’s CPI inflation grew YoY by 8.6% in the US and 8.1% in the Eurozone) and growth expectations were again lowered against clear signs of a major deceleration. Despite COVID-19 appearing to be under control, noting variant risks, the implementation of monetary tightening has added even more pressure. Turing to the East, Asia’s major economies did not see stagflation as consumer inflation remained low (May’s CPI inflation grew YoY by 2.1% in China and 2.5% in Japan) and the region continued to have growth (the OECD kept China’s 2023 growth expectations the same and raised Japan’s). Central banks and governments continued to provide support to their respective economies, while the COVID-19 situation in China improved but remains the elephant in the room.?

A worse-than-expected rise in inflation and higher associated volatility led most major indices to finish Q2 2o22 in bear market territory, bringing an end to one of the worst H1s for markets on record. In Q2 2022, global equities dropped by -13.5% (MSCI ACWI World Index Total Return, USD hedged), as Asia and Europe outperformed the US (MSCI Asia Index: -11.8%; Eurostoxx 50 Index: -9.4%; S&P 500 Index: -16.1%). With virtually nowhere to hide, investment grade (“IG”) bonds fell by -6.6% (Bloomberg Global Aggregate Index Total Return Index, USD Hedged) but outperformed high yield (“HY”), which dropped by -9.8% (Bloomberg Barclays Global High Yield Total Return Index, USD Hedged). Despite this drawdown, there were opportunities for long-term investors who sought to recalibrate given stagflation or recession plays in the US and Europe and stagflation or a lack of it in the West and East.

Our strategy performance

Our Tyrus Capital Global Convertible strategy returned -5.7% in Q2 2022 (SI USD acc. Class), with a 260-day volatility at 7.7%. While we are disappointed with a negative return, we did continue to outperform balanced funds and our convertible bonds (“CBs”) peers this year. We are also pleased to see our top-decile rank consolidated on both a YTD and 5Y rolling basis among all global CB funds listed on Bloomberg. Turning to performance, we were able to mitigate the market’s negative impulse on a relative basis due to our thematic macro positioning, better convexity on name selection, dynamic risk control of both duration and credit, and careful selection of profiles from a valuation perspective.?

Our summary view

Main focus: Stagflation. Last quarter we pivoted away from a pandemic-driven scenario towards a stagflation-driven one, while acknowledging that the pandemic appears under control but presents a persistent risk in the background as there remains a possibility that a new variant of concern will surface. Our main observations have since been that as we approach peak inflation, stagflation: (a) needs to be treated on a regional basis; and (b) is inherently unstable and therefore has a short lifespan. From a regional perspective, the US has higher-than-expected inflation that needs to peak before a sustained market rebound can emerge.

The initial supply-side impulse linked to COVID-19 bottlenecks has substantially diminished as the second impulse related to the war in Ukraine remains exacerbated. The country needs to be careful to soft-land its economy and avoid a recession, and we think it is likely to do both. We are concerned about the Fed’s rate-hiking policy and the mixed macroeconomic picture, especially record low consumer confidence data; however, it can be hoped that the Fed will ease off policy-tightening when (or if) the unemployment rate veers towards 4.5% given how resilient the job market currently appears. Europe is in the worst spot as it has high inflation, little growth (thanks to its direct exposure to the consequences of Russia’s invasion of Ukraine), no real fiscal space, and political gridlock – a recession seems inevitable. The ECB seems to be the only hope for the region, but it faces the unenviable job of having to finally hike rates without pushing peripheral spreads over the edge.

A credit contagion is therefore a real risk, but one we hope will be avoided. Asia so far remains insulated from supplydriven inflation and enjoys growth (and stimulus). Despite potential problems in real estate, regulation, and geopolitics (and bearing in mind COVID-19 and associated lockdown risks), China appears to be an unlikely safe haven in this stagflation environment. Nuances aside, the ultimate question we turn to is how long this stagflationing environment last? Either growth or inflation or both will have to give as stagflation cannot be sustained over a long period. Keeping this in mind, US inflation looks near its peak due to a combination of base effects and seasonality, albeit food prices are expected to remain elevated. However, inflation expectations have re-anchored upwards, implying that inflation may take longer to normalise (e.g., 2024-2025) unless we have a sudden, deep, and very undesirable recession. Once inflation does eventually plateau, monetary policy will take centre stage in guiding economic and market trajectory.

All the rest: COVID-19 in Asia is our biggest worry outside of stagflation and is essential to monitor. So far, the message from China on zero-COVID policy is mixed while the macroeconomic picture is more positive. For example, Bloomberg’s Stringency Index indicates restrictions are still in place (noting there could be a potential lag in data), while PMI manufacturing bounced back from April lows to recover to pre-lockdown levels of 50.2 as of June. In Europe, the Ukraine scenario has not gone away despite media coverage having dwindled somewhat. A ceasefire would still be a positive, but we would not expect an immediate impact on commodities, particularly in energy due to the longer-lasting geopolitical evolution in this context.

Our investment themes and how we are positioned

Taking the above foundational views into account, we formulate our key investment themes and portfolio positioning as follows:

Where does this leave convertibles?

Can convertibles be the Dark Knight for asset allocators in this environment? We think they can, specifically in two distinct ways. The first is as a saviour to fixed income allocation. Looking at the typical stagflation cycle, it is important to point out that the “villain” in fixed income has not yet revealed itself. Fixed income is currently suffering from the impact of duration and rate hikes, but a second possible impact of credit contagion has yet to emerge. Should this happen, this could easily translate into another -10% in performance for the asset class, with European HY looking the most vulnerable. Opting for an investment grade convertible bond solution in such a scenario is cheaper in terms of relative spreads and keeps duration low while improving credit, ESG, and liquidity and suppressing volatility. The second is more for the balanced manager. A 60:40 split does not work. In stagflation, equities will lead the rebound, not fixed income (treasuries have some duration for a little while longer, but that depends on what central banks do). However, timing and volatility makes equity investment challenging, especially given the very real threat of a bear market trap (note that we have already had three this quarter). Here, convertibles (if well managed from a duration and credit perspective) provide a compelling solution with lower volatility and whose asymmetric access to equities provide you with an overwhelming advantage in market timing. As the charts below show, convertibles tend to follow the leading asset class on a rebound out of previous crises.

Best wishes,

D. Regnier