Market Overview
Bond markets began the quarter at distressed levels due to the regional banking crisis in the US, which was dominated by the collapse of Silicon Valley Bank and two other large institutions. However, widespread fears about the health of the global banking sector were contained as contagion from the crisis seemed to be limited.
Generally, during the second quarter, there were two main drivers of fixed income markets: inflation and the response of central banks, and a positive quarter for risk assets (including credit markets).
Central banks continued to tackle inflation with rate hikes. However, inflation remains stubbornly high and significantly higher than central banks’ targets. Higher interest rates and duration (interest rate risk) were headwinds for fixed income assets.
Risk assets – such as corporate bonds and equities – performed strongly during the second quarter as economies proved to be more resilient than previously feared. In our view, the threat of recession – particularly in the US – has been pushed back for now. Risk assets were also boosted by containment of the US banking crisis earlier in the year. The raising of the US debt ceiling by Congress also made the prospect of a US debt default less likely, a further boost for the economy.
In Europe, economic indicators suggest the region is in a mild recession but not in danger of economic collapse. Demand for services, particularly in the travel and leisure sectors, is supporting the economy although the manufacturing sector remains in the doldrums as new orders are weak and production remains low.
Fund Review
During the second quarter, the fund generated a negative total return and underperformed its benchmark.
As interest rates rose, we took advantage of the increase in yields to reduce our short duration positioning and add back exposure at the very long end of the maturity curve. This included adding 30-year UK gilts and long-dated Japanese government bonds.
After a difficult first quarter for financial assets following the US regional banking crisis, the financials sector has delivered positive returns and has been further buoyed by the takeover of Credit Suisse by UBS. We took advantage of this in the portfolio by reducing our exposure to subordinated financials and hybrid bonds, selling our holdings in Zurich, Phoenix Group and BNP Paribas.
Finally, the fund was negatively impacted by the strength of sterling during the quarter. The pound delivered one of the strongest performances of the G7 currencies as the Bank of England accelerated its rate hiking programme due to the inflationary backdrop. This had a considerable impact on total return, in particular the Japanese yen portion of the fund which fell by 10% against sterling as the Bank of Japan maintained its yield curve control policy.
Outlook
Looking ahead, we expect to see the themes of the second quarter continue into Q3 with additional rate hikes from central banks and a general resilience in credit markets. However, as the impact of previous rate hikes starts to feed through, particularly on mortgage rates, consumers will likely increasingly feel the burden.
Inflation remains high, although some commodity and energy prices have eased from their peak. Troublingly, core inflation is being supported by multi-decade low unemployment rates and strong upward pressure on wage inflation. Central banks in developed economies have indicated that they have not yet finished hiking rates, and we could see more by year-end, which would keep bond yields at a high level. We expect to see the rate-hiking cycle pause by the end of this year and inflationary pressures to ease as the previous rate rises lower disposable incomes. Interest rate cuts will only be contemplated as evidence of lower inflation becomes clearer. Any further hikes will most likely remain data-driven, however, and contingent on financial conditions.
We would expect stronger performance from financials and consumer-focused sectors as the economic backdrop remains benign, with consumers continuing the so-called ‘revenge spending’ theme that began after the end of the Covid-19 pandemic. However, these sectors could be impacted later in the year as the effect of previous rate hikes start to feed through. Also, if the rate-hiking cycle continues it could push some of the more precarious economies into full recession.
Important Information
The value of investments may fall as well as rise and investors may not get back the amount invested.
The views expressed in this document are those of the fund manager at the time of publication and should not be taken as advice, a forecast or a recommendation to buy or sell securities. These views are subject to change at any time without notice.
This document is issued for information only by Canada Life Asset Management. This document does not constitute a direct offer to anyone, or a solicitation by anyone, to subscribe for shares or buy units in fund(s). Subscription for shares and buying units in the fund(s) must only be made on the basis of the latest Prospectus and the Key Investor Information Document (KIID) available in the literature section.
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