David Roberts

Q2 strategy – Positioning for an uneven recovery

David Roberts

Executive summary

Since November 2020, risk markets have powered ahead, buoyed by Covid-19 vaccines that have exceeded all efficacy expectations. Equity markets have hit record highs and corporate bond spreads are well below long-term averages. Government debt has faltered – US Treasuries had the worst quarter in 40 years in Q1 2021 – as reflation fever takes hold.


Risk-free yields are higher, and there is expectation they will go higher still. Despite this, risk assets have had the most fleeting of wobbles. US inflation-protected securities are pricing for 2.5% inflation in the medium term, and if that proves true and sustainable, the Federal Reserve may act sooner than equity markets are currently thinking. The Bank of Canada has already started tapering bond buying and the European Central Bank (ECB) is rumoured to have decided against increasing PEPP (Pandemic Emergency Purchase Programme), which it will possibly confirm in June.


Until the point at which markets are spooked by rising rates, we expect a drift higher in yields and modest tightening of credit spreads. The risk of chasing the latter, especially in regard to cyclical sectors, is in our opinion too great for the prospective rewards.


It does feel a bit like “goldilocks” – low debt service costs and rising EBITDA (earnings before interest, taxes, depreciation and amortisation). Demand from retail buyers for bonds is falling and, should central banks decide to rein in quantitative easing, investment grade spreads will find it difficult to progress. High yield (HY) remains steady for now, given the combination of low debt service costs and improving earnings. Our strategic funds remain underweight duration versus our long-term averages, slightly underweight investment grade and modestly overweight high yield.


Macroeconomics and rates

Big dip, bigger bounce? The latter part of 2021 looks set to be a bumper period for growth. Of course, for many economies that will simply be repairing some of the damage done from lockdown in 2020. There is growing discrepancy in growth patterns, which are largely driven by the initial responses to Covid, subsequent access to a vaccine and the willingness to vaccinate.


  • The US arguably locked down the least and vaccinated quickly: hence the H1 recovery
  • Europe had a stringent lockdown and then was slow to vaccinate: a delayed recovery
  • Emerging markets suffered from complacency and a lack of vaccine access: the dip continues and they will recover slowly

Gross Domestic Product (GDP) growth less potential

Q2 strategy – Positioning for an uneven recovery

Source: JP Morgan, seasonally adjusted (sa) annual rate of GDP, April 2021.

Although global growth is likely to be significant in 2021, the timing will vary from region to region. This will have ramifications for portfolio positioning.

First, geographic allocations may matter more than usual. Second, growth and inflation may remain above normal levels for a protracted period of time rather than spiking higher and then receding just as quickly. If so, this may support risk in the medium term.

To try to determine the speed and sustainability of any rebound, we look at three key areas:

  • Unemployment: high by recent standards and muddled by government retention schemes
  •  Consumption: the number one driver of growth across the G7
  • Inflation: rising as expected and a threat to the free money foundation that risk assets’ returns have been built upon

Unemployment: Job losses around the globe rocketed way beyond what we saw in 2008. However, government sponsored schemes, furloughs and short-term working smoothed the impact. As the chart below shows, economic reopening in the US suggests that recovery to “peak employment” may be much quicker than after the Global Financial Crisis (GFC).

Despite March gains, nonfarm payrolls remain 8.4 million below pre-Covid levels


Q2 strategy – Positioning for an uneven recovery

Source: BLS, HaverAnalytics, Deutsche Bank. April 2021


Other measures suggest employment losses are greater than the nonfarm payroll numbers, which currently remain 8 million below pre-pandemic levels. However, the recovery looks swift and the financial impact of unemployment (so far) has been mitigated by fiscal action.


Consumption: Spending initially dropped when the pandemic hit. Incomes remained high but confidence fell, and it was really only in the early stages of 2021 that demand began to recover.


Q2 strategy – Positioning for an uneven recovery

Source: JP Morgan, March 2021.


Thanks to government support (and booming financial assets), income and savings rates roared upwards in 2020. With the vaccine rollout and fears of mass long-term unemployment receding, consumption is rising fast. What does all this mean for prices?


Inflation: There are many sources of inflation. That aggregate prices are rising compared with last year is factually correct but how long this lasts and how broad it will be is important. Central bank policy is fixated on prices, but with high levels of debt (government, corporate and personal) there is clear reluctance to tighten monetary policy. The challenge is simple – to keep inflation (or rather inflation expectations) low enough that people will continue to support debt markets and not flee from financial assets en masse.


Breakdown of year-on-year eurozone (EZ) inflation  

Q2 strategy – Positioning for an uneven recovery

Source: Pantheon Macro, contribution to inflation in percentage points (pp). April 2021.


We have used the chart above previously to highlight the cyclical nature of eurozone prices. The recovery in energy (demand and confidence related) now makes a “normal” contribution from previous abnormally low levels.


US data show material price rises in “sought after” goods, suggesting actual inflation (which influences expectations) may be much higher. Further gains are likely and in Europe, as elsewhere across the G7, central bank inflation targets could well be breached in coming quarters.


Macro conclusion: Unemployment has been held in check. Much of the huge fiscal stimulus across the G7 (and beyond) has propped up personal balance sheets. Coincident with the vaccine rollout, consumption has started to rebound. An added fillip has come/will come from economic reopening, barring new, more virulent Covid strains. Falling unemployment and strong consumer balance sheets seem to be translating into inflation (remember the Phillips Curve?), some of which is cyclical in nature and some is seemingly more structural. This is constructive for risk, perhaps, but the risks of monetary tightening are rising.


Rates Positioning

Yields moved higher in Q1. US Treasuries had their worst quarter for 40 years as fears of reflation gripped the market. And, of course, prices were insanely high at the end of 2020: the UK was expected to take rates negative and the ECB to be on hold for a decade, neither of which now seem realistic.


For most of 2020, the duration in the Liontrust Strategic Bond and GF Strategic Bond funds ranged from 2.5 to 3.0 years. The sell-off in rates has meant that range moved up to 3.0-3.5 years in April, while US yields rose from 0.8% to 1.6% in three months. Inflation has also risen and we expect it to go further.


Government bonds remain poor value in nominal terms and shockingly bad once adjusted for inflation. So, despite the increase in yields, we remain well below our longer-term “neutral” duration of 4.5 years. The recent small increase in rate risk in the strategic funds is largely tactical in expectation of a rates bounce from short-term oversold conditions, and therefore positioning in the Liontrust GF Absolute Return Bond and the Liontrust GF High Yield Bond funds is little changed from 2020.


The US Treasury market performed especially poorly in Q1, but in early Q2 signs are that the better absolute and relative value was attracting buyers. Although yields in Europe rose in early April, they fell in the US. As a result, we altered our overall geographic stance.


We continue to have the majority of our rates exposure in the US. However, we have added Australia, Sweden and Switzerland. The latter two are relative value expressions against a short position in core Europe. We reduced that euro short in April, selling US into Germany as American bonds rebounded swiftly from the end of March lows.


Summary: We remain underweight versus long-term duration averages but less so, and a reduction in US into Europe to exploit cross-market relative value opportunities.


Spread product

Investment grade and high yield markets continue to perform well. Total returns from investment grade bonds have been held back by the high correlation to government debt – spread tightening has been largely offset by higher yields on underlying sovereign securities. High yield has made money in an otherwise negative bond environment. The power of income generation has again been at the fore. High yield companies benefit from cheap finance and fiscal-led earnings recovery and therefore, although not cheap, there is every possibility these bonds can rally further.


There are a series of “however” here, which are shown in the following charts. Leverage remains high and interest coverage poor. The collapse in earnings (EBITDA growth) needs to reverse soon – the forward-looking nature of the market highlights how much earnings recovery is already in the price. We do expect interest coverage ratios to gap higher in coming quarters and the strategic funds are modestly overweight high yield while the Liontrust High Yield Bond Fund is fully invested. We also take comfort from the fact that growth in debt was subdued last year.


Q2 strategy – Positioning for an uneven recovery

Source: Deutsche Bank, April 2021.


No quasi-equity

Our funds concentrate on core bond markets. We generally avoid other forms of risk, including equity and equity-like structures. On occasions, we will buy hybrid corporate or subordinated bank debt. However, these assets are highly correlated to each other (and to equity markets) in times of stress. This reduces their attraction as equity diversifying instruments. With equity indices close to all-time highs, such higher risk “bonds” have performed well. Had we owned them, we would be selling now – we much prefer diversified, idiosyncratic high yield to systemically linked financial debt.


Tighter spreads for sub debt and additional tier 1 capital (AT1s) while senior debt spreads widened

Q2 strategy – Positioning for an uneven recovery

Source: Deutsche Bank, Markit Group. April 2021.


As the charts above show, excess spreads on senior bank debt have widened modestly in recent months. That of deeply subordinated bonds has actually tightened. This makes little sense – they should move in the same direction. The technical demand for AT1, especially from income-hungry investors, means they have ignored the moves in government bonds, while lower-yielding senior debt has not. AT1 looks an accident waiting to happen – the question is, at what level of government bond yields do investors flee the asset class? Bear in mind, the exit door looks pretty small.

Concentrating on robust sectors

There are some parts of the market we continue to avoid. Core to our investment process is sustainability, which, for us, has two linked meanings:


  1. Is the company likely to survive under foreseeable conditions? We generally prefer core, stable earnings sectors and avoid themes. For example, our weighting to travel and tourism and to consumer discretionary sectors is normally low. We see little point in chasing semi-distressed parts of the market today and suggest if investors want that kind of risk, it is better done via equities where the rewards for success are greater (as of course is the price of failure!).

  2. Is the company well placed to capture evolving themes and trends? As an example, in the strategic funds our carbon footprint is much lower than if we simply bought the global bond index. Whilst we have mandated sector exclusions, we also recognise the financial and environmental benefit of investing in areas which will receive long-term buyer support. At present, though, our exposure to so called “green bonds” is light. In many cases, a premium is demanded for individual holdings, hence our preference to focus on portfolio level metrics.

Summary: a preference for high yield over investment grade bonds; no desire to chase extreme risks, CCCs or distressed sector themes; and we continue to avoid systemically linked quasi-equity bonds.



Q1 saw rates markets move higher and credit perform well, especially high yield. Vaccine success and attendant reflation themes made the headlines. US Treasuries had their worst quarter for 40 years. We took advantage of higher rates to add a little duration, more tactically than strategically.


In recent months, we have sold down some corporate credit. Although conditions remain favourable in the short term, especially for high yield, the excess income compared with government securities has narrowed. There feels little need to panic out of investment grade, although we deem it prudent to be modestly underweight to create the opportunity to buy on any material dips.


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Key Risks

Past performance is not a guide to future performance. Do remember that the value of an investment and the income generated from them can fall as well as rise and is not guaranteed, therefore, you may not get back the amount originally invested and potentially risk total loss of capital. Investment in Funds managed by the Global Fixed Income team involves foreign currencies and may be subject to fluctuations in value due to movements in exchange rates. The value of fixed income securities will fall if the issuer is unable to repay its debt or has its credit rating reduced. Generally, the higher the perceived credit risk of the issuer, the higher the rate of interest. Bond markets may be subject to reduced liquidity. The Funds may invest in emerging markets/soft currencies and in financial derivative instruments, both of which may have the effect of increasing volatility.


The information and opinions provided should not be construed as advice for investment in any product or security mentioned, an offer to buy or sell units/shares of Funds mentioned, or a solicitation to purchase securities in any company or investment product. Always research your own investments and (if you are not a professional or a financial adviser) consult suitability with a regulated financial adviser before investing.

Wednesday, May 12, 2021, 7:58 AM