Market Overview
Bond markets were calmer during the second quarter than the preceding one, largely because the banking sector’s troubles, dominated by the collapse of Silicon Valley Bank and the UBS-Credit Suisse merger, were largely confined to the prior period. That said, there was initially some contagion when First Republic Bank fell into trouble in April. This kept the subject of banking sector stability on investors’ minds when assessing risk and return and this consideration factored into how we managed our funds during the quarter.
The Bank of England (BoE) hiked the base rate twice over the period, by 0.25% in May and surprising many with a 0.5% rise in June. This sudden acceleration in rate rises appears to reflect a turning point in BoE strategy. Like many commentators, the UK central bank had expected inflation to fall as energy prices declined. However, while there have been modest declines in CPI and RPI data, the issue of core inflation remains a problem.
In the UK, inflation has become an internalised issue. Service sector inflation has been climbing even as macroeconomic data in the global economy has weakened. This appears to have prompted the BoE to act more aggressively, though higher rates could feed wage inflation if workers are able to secure offsetting pay rises from their employers. The BoE likely needs to generate some form of slowdown, perhaps even a recession, to regain control of inflation.
Fund Review
We launched the fund last June at a time of rising rates, which acted as a headwind to its performance. However, it recovered towards the end of the year and the first quarter was relatively calm as the pace of rate hikes seemed to be under control. The second quarter has been more challenging, as the likelihood of further rate hikes became apparent due to disappointing inflation data.
The market is now pricing in a peak BoE base rate of 6.25%. For perspective, two-year gilts – which is roughly the duration of this fund – moved from 3.5% to 5.3% during the quarter. The last 140 basis points of this increase came between May 19 and June 30 alone. With two-year bonds declining at this pace, it has been challenging to outperform the benchmark.
There has been little activity in the fund, with only 10 trades carried out during the quarter. As the rising rates outlook has been reflected in asset prices, we have looked for opportunities to add duration and yield. We sold some short-dated supranational positions and bought into a two-year CPPIB bond, a Canadian crown corporation. This AAA-rated debt, backed by the Canadian government and yielding 6.08% was bought with the aim of stabilising the fund’s long-term returns.
Outlook
The imminent holiday period could potentially bring calm to bond markets, as there are no major reports or macro data due to be published. By August, we should have a clearer idea about the stubbornness of inflation and in turn how the BoE will act. If the monetary policy committee feels progress has been made, we could see a return to 0.25% rate hikes (or even no hikes) and this would bring relief to the market. Conversely, perhaps motivated by being criticised for acting too slowly in previous months, further unexpectedly high inflation data could lead it to implement further aggressive rate hikes. If the base rate continues to go up in 0.5% increments, it could cause greater volatility as traders reassess how far the trend has to run. There is potential for the expected peak rate to edge higher.
We will reassess the likelihood of each of these scenarios as fresh data appears. We are taking positions in the fund to secure the higher yields available – but we are proceeding with caution. We will continue to manage the fund to maintain a degree of liquidity that gives us options when opportunities arise.
One specific area of opportunity we are targeting is new issuances; we have already participated in several this year. These can be a good way of adding both yield and duration to the fund. We will also continue to add government debt where we see value. Overall, our aim is to keep the fund nimble and able to take advantage of opportunities when they arise, in what is likely to continue to be an unstable market until the cycle returns to a rate-cutting phase.
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.
Promotion approved 18/07/23
