Q3 2022: "Money for Nothing"

"That's the way you do it; Money for Nothing"

- Dire Straits, 1985, Brother in Arms album

What has happened?

The stagflation regime remained well-entrenched in Q3 2022.

In the US, there was a clear shift in focus from headline to core inflation as pressure from supply-side components started to ease only to be replaced by pressure on the shelter component which helped drive a rise in core CPI inflation to +6.3% YoY. Wage pressure increased as the great resignation movement supported the job-worker gap and spurred double-digit wage growth among the lower decile of the income distribution, all against the uncomfortable backdrop of lower productivity. Chairman Powell was left with little choice but to carry on his aggressive tightening programme and took the upper bound of the Fed funds rate to 3.25% by the end of the quarter. Crossing back over the Atlantic, stagflation was even more pronounced in Europe. Growth remained muted and growth projections were lowered… again! More concerning was that Eurozone inflation kept rising and overtook the US in terms of level: headline CPI inflation in Europe rose from +8.6% YoY as of June to +9.1% as of August, while the same data for the US fell from +9.1% to +8.3%. This prompted the ECB to hike rates to 1.25%. The situation in Ukraine still has no clear end in sight and was made worse by the stoppage of Nord Stream gas distribution after pipelines concurrently exploded. The difficulties felt in the West made the East stand out as a relative winner on the macro front (China and Japan at least). Despite the strict adherence to zero-COVID and real estate woes in China, North Asian countries saw lower inflation and maintained more growth, backed by monetary and fiscal support. Unfortunately, southern Asia fared less well.

A mismatch in expectations between markets hoping that weak data would lead to the Fed backing off its hiking trajectory and the Fed’s own resolve to keep going led to more bear market bull traps this quarter. In Q3 2022, global equities dropped by -4.6% (MSCI ACWI World Index Total Return, USD hedged), led primarily by losses in Asia ex. Japan while Japan outperformed (MSCI Asia ex. Japan Index: -13.7%; Nikkei 225 Index: -0.8%). With virtually nowhere to hide, investment grade (“IG”) bonds fell by -3.3% (Bloomberg Global Aggregate Index Total Return Index, USD Hedged) but were outperformed by high yield (“HY”), which dropped by -1.4% (Bloomberg Barclays Global High Yield Total Return Index, USD Hedged).?

Our strategy performance

Our Tyrus Capital Global Convertible strategy returned -1.5% in Q3 2022 (SI USD acc. Class). While the quarter was undoubtedly difficult for most, we outperformed the broad convertible bond ("CB") index, equities, and traditional fixed income (US and EU sovereign included). However, we lagged the IG CB index due to the index having a higher exposure to European CBs (which make up a much larger weight of the IG index than the broad one) falling less than their American and Asian cohorts, noting that we still outperform the IG CB index on a YTD basis. We were again 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, our focus on convexity, low duration, and quality credit helped us navigate markets, especially in Asia ex. Japan which saw significant weakness

Our summary view

Main focus: We expect the current stagflation cycle to follow a 3-phase process: (i) “Duration”, (ii) “Propagation”, and (iii) “Stabilisation” (see chart below). In Duration, central banks hike interest rates to starve inflation’s momentum, while the real economy and credit markets begin to feel these effects during the second phase, Propagation. The severity of this impact will depend on just how high those rates peak and how robust the economic landscape is in dealing with the shock. In the third phase, Stabilisation, the dust settles, and we move to the next cycle, likely a regime of low inflation and low-to-moderate growth like that of a few years ago. Regionally, we think that the US is reaching the end of its Duration phase. Once the Fed halts its rate-hike trajectory, the US will move into the Propagation phase. Here, real-world consequences will show themselves, bearing in mind that it is how mild or severe a US recession is that will determine optimal asset allocation decisions. We feel that the US is still likely to move through the Propagation phase and into the Stabilisation phase faster than most, given careful management, early mover advantage of policy, and relative economic strength. Turning to Europe, the region entered the Duration phase this summer with the ECB only at the very start of its rate-normalisation cycle, while the pain of a weakening euro is only aggravating the inflation backdrop. However, Europe’s Propagation phase is more concerning as the region’s fractured and artificially supported credit markets are going to be called out – expect defaults to rise at the very least! This rude awakening will likely mean a longer and deeper hit to the real economy and a muchdelayed wait for the Stabilisation phase to be welcomed in. Lastly, China and Japan should dodge stagflation all together thanks to the welcome decoupling of monetary and fiscal policy easing, signs of actual growth (in China at least) and lower inflation readings. Note that both China and Japan implemented further stimulus during Q3 to boost their economies, with more to follow in Q4.?

All the rest: While the focus in the US is very much on trying to predict the Fed’s next steps, less emphasis has been put on strengthening the greenback. Investors rushed to USD for shelter over the Fed’s hiking schedule and economic uncertainty, with the currency now almost at parity with GBP and EUR. This will impact both developed markets ("DM") and emerging markets (“EM”), multi0nationals with US exposure, and those with USD-denominated debt, to name a few examples. We expect Q3 earnings and Q4 outlooks to show the extent of this strengthening. In Europe, the pandemic continues to be well managed, but political uncertainty has again come to light, this time in the UK, where policies by the new government were not well received, and Italy, where a centre-right coalition is now in power. In Asia, China and Japan seem to be carrying on with their own playbook, with zero-COVID and real estate holding back China and broader financial conditions hampering Japan. Assuming these more localised issues can be rectified and given current positive fiscal and monetary support, these regions could give rise to a positive surprise going into the end of the year (in relative performance at the very least). Although all these things are significant, they become a side show to the main act of stagflation when it comes to investment positioning.

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?

So far, we have performed well relative to our peers thanks to our positioning. One repetitive comment that we are hearing among allocators is that they see the end of the “there is no alternative” (“TINA”) era and the rising age of “there are reasonable alternatives” ("TARA") as, embodied by a “safe” US 10Y treasury that is yielding >4%. We understand their frustration given the deeply negative drawdown on both equities and fixed income this year. However, this mindset would essentially lock in a -20% to -25% loss if one switched from equities to sovereign bonds, which effectively means you are throwing away significant bounce-back potential in exchange for a return profile that will likely take 4 to 5 years to recoup losses – we see this as “money for nothing” for active managers. In our view, treasuries have a place in asset allocation, but they only make sense if they effectively provide a source of decorrelation. However, we are not at that stage yet – perhaps in 2023 as we enter the Propagation phase after interest rates have peaked.

This brings us to convertible bonds or as we like to refer to it: “defensive income derived from equity factors”. For us, equities are the light at the end of the tunnel and the opportunity to overturn losses suffered by traditional asset classes this year. However, the problem is that the tunnel could be quite long, especially if the US hits a hard landing in a severe fashion. Therefore, convertibles and other equity-factor alternatives are very interesting: they can make that ride smoother, provided you have chosen the right vehicle of course. We recommend avoiding less liquid and HY-driven strategies and favour macro-based allocations with a focus on valuations. “That’s the way you do it!”

Best wishes,

D. Regnier