In a world where potential pitfalls loom around every corner, Peter Fitzgerald and Ian Pizer explain why investors need to look beyond what financial models are telling them to keep portfolios resilient to the challenges ahead.

Read this article to understand:

  • Why US rate cuts may be further away than expected
  • Why investors need to be pragmatic, limit risk, and trade positions more actively
  • Why fears of a US debt default appear overblown

As the focus on US regional banks intensifies, financial markets are becoming convinced US interest rates have peaked. Expectations are high the Federal Reserve will prioritise supporting economic growth and markets are pricing in a roughly even chance US rates will start falling as soon as June.    

However, the fact core inflation is proving far stickier than many had anticipated is complicating the task facing the central bank in a manner not seen since the 1970s. Throw concerns around the “risk-free” status of US government bonds into the mix and the outlook for financial markets is highly uncertain, no matter how clichéd it may be to say so.

Peter Fitzgerald (PF) and Ian Pizer (IP), managers of our AIMS Target Return strategy, tell us why investors need to be humble in 2023, keeping an open mind and trading positions more actively in response to market gyrations.

You have expected inflation to remain stickier than markets anticipated for some time. Have you begun to express this view more strongly within the portfolio?

IP: As you get towards the end of the economic cycle, you have got to be more aware of the potential for the market to anticipate a turn. You might get one or two more rate hikes, but you have to make sure that you are not overstaying your welcome on those trades.

We traded from a short bias on rates, but as the market began to price in more hikes, we moved back towards a neutral position and rely more on relative-value trades.

As you get towards the end of the economic cycle, you have got to be more aware of the potential for the market to anticipate a turn

We have been running a position that will benefit from rates rising more in Europe than the UK, aware this would leave us less exposed in the event there were a big external shock, such as happened with the crisis in US regional banks.

While the Fed might be hiking for most of the rest of the year, if inflation is sticky, and US rates end up at six per cent, that is a trade that probably rewards you slowly. By contrast, rate expectations could fall quite dramatically, as we saw with the collapse of Silicon Valley Bank (SVB), so it is dangerous to play the trade aggressively. We are trying to ensure the portfolio can eke out some return without leaving us overly exposed to the risk of an exogenous shock.

PF: You potentially make money slowly and lose it very quickly. While we disagree with the idea rates will fall sharply from here, the challenge is that you will lose a lot more if you are wrong than you will make if you are right.

IP: You may not even be wrong, but the market might be willing to price a more aggressive rate cycle than you are able to hold your position through. The likelihood, particularly post SVB, that the market is going to price in aggressive hikes from the Fed is slim. Were that level of rates to be reached, it is far more likely the market would only be willing to price those hikes one at a time, always incorrectly believing that each move will be the last.

But if the market gets spooked for any reason, you may be sitting on a big loss, even if your view is ultimately right. What makes trading in the rates market even harder is the high level of spikes in volatility. For example the size of the move in two-year rates post SVB was as big as anything seen in 2008.

What do you put that down to?

IP: Illiquidity. Market makers’ risk tolerance is way down on where it was in 2008.

PF: Not only are investment banks’ balance sheets smaller, but hedge funds’ are bigger. It does not take much for several hedge funds to try to change their positions to effectively move the market.

Are rates close to peaking?

IP: You have to be more humble in this cycle than previously. The economic models that tell us inflation will fall this year are the same ones that told us inflation was going to fall last year and the same ones that told us it was transitory. Something appears to have changed but you cannot pinpoint what it is.

You have to be more humble in this cycle than previously

We can see headline inflation is coming down and a little softness in the labour market. But we have not seen a proper inflationary spike since the 1970s when the world was so different. In that environment, even when the economy looked weak and inflation looked like it was coming off sharply, it was easy to reignite it. We do not know if that is going to be the case now. Your central case is that inflation will come off, but your conviction in the models is weaker.

Where do you see inflation heading to?

PF: We see headline US inflation coming back down to about 3.5 per cent later this year. But the trend in core inflation is less clear, particularly in Europe. Whereas globalisation was deflationary, the reverse is now happening. So, instead of having a deflationary tailwind, you've got an inflationary headwind against asset prices.

IP: In the US and UK core inflation appears to have peaked and stabilised and there are hopes it is starting to edge down but it has not stabilised yet in Europe. Looking further ahead, while some people think once we come through this cycle we return to the old world of persistently low inflation, we are not in that camp.

What does being humble mean in terms of overall positioning?

IP: We thought UK rates looked attractive relative to European rates after the turmoil of last autumn subsided. As it turns out, we made more money on the UK leg, partly because we traded it more actively, but you are looking to be a little bit more pragmatic and limit your overall exposure. That way, in the event something unexpected happens, the portfolio is less dependent on getting the big call right.

Have we moved into a world where the holding period for trades needs to be shorter?

PF: It has been shorter, but not just the holding period. We have been short US rates for the bulk of the last 18 months, but we have traded that position much more actively as market pricing changed.

Equity markets have proved resilient in recent weeks. Why is this?

PF: Our view was that this was not a systemic banking crisis, as the banking industry is much more robust [than it was in the global financial crisis]. Whereas a lot of commentators maybe didn't see through that, markets broadly have thanks to the speed of reaction of policymakers.

Inflation is going to be a problem without a recession. And, if you get a recession, it is not good for risk assets

Having said that, inflation is going to be a problem without a recession. And, if you get a recession, it is not good for risk assets. There appears to be a false narrative that in a slowdown the Fed will not have to continue to raise rates; it might even be able to cut them, and therefore risk assets can continue to rally. Such a Goldilocks scenario appears unlikely.

IP: Equities traditionally peak around two months before the start of a recession. Although many think we need to see a recession to get inflation down, and while that may be bad for equities, historically the market has waited for a clearer sign of a downturn.

The trouble is everyone has already moved to the sidelines. The number of investors cheering this rally are few and far between. It has been an unloved rally. That may continue for a while longer. Some investors are buying back in, but not comfortably.

Are rising rates likely to cause problems for other sectors beyond banking?

IP: Everyone is talking about commercial real estate, but it had been under pressure for a while. The most rate-sensitive parts of the market have already taken a hit and we expect more of a slow bleed from here rather than some massive crack.

The other area at risk is small to medium-sized US businesses reliant on bank funding rather than capital markets, particularly away from the large cities. We don't expect a sudden stop in credit provision, but it is going to be harder to come by. As much as the large banks are benefitting from deposit inflows, they are not set up to serve these companies.

PF: The areas still vulnerable are those with business models that are not necessarily profitable and require continuous capital raising to fund ongoing expenditures. If you have a business that is not cashflow positive and is required to raise capital to continue to fund its expansion, it is likely to come under pressure.

Is there any risk of the US government defaulting given the impasse over increasing the $31.4 trillion borrowing limit, or is this a storm in a teacup?

IP: It could be messy and there may well be some level of government shutdown, but it is unlikely any coupon payments will be missed. It is still worth thinking through the implications of a missed coupon or redemption. Were this to happen, the risk that the payment is not made at a future date is as close to zero as you can get. Essentially, not only would the recovery rate be 100, but all missed interest payments would be made too. Although it may create an odd shape to the Treasury-bill curve, we do not believe this implies US Treasuries are at risk of losing their ‘risk-free’ status.

We do not believe this implies US Treasuries are at risk of losing their "risk-free" status

A government shutdown and the possibility of delayed payments to households and businesses could hit the economy at a time when it is vulnerable. In all likelihood, equities are far more vulnerable to this and, perversely, Treasuries are actually far more likely to rally.

It is worth remembering that when the UK was first considered to be at risk of losing its AAA status, there were similar concerns regarding investment mandates written when this wasn't thought a possibility. In the end, when it did get downgraded, the impact was minimal. Gilts remain considered within mandates and the market as the risk-free sterling asset of choice.

Related views

Important information

THIS IS A MARKETING COMMUNICATION

Except where stated as otherwise, the source of all information is Aviva Investors Global Services Limited (AIGSL). Unless stated otherwise any views and opinions are those of Aviva Investors. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Information contained herein has been obtained from sources believed to be reliable, but has not been independently verified by Aviva Investors and is not guaranteed to be accurate. Past performance is not a guide to the future. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested. Nothing in this material, including any references to specific securities, assets classes and financial markets is intended to or should be construed as advice or recommendations of any nature. Some data shown are hypothetical or projected and may not come to pass as stated due to changes in market conditions and are not guarantees of future outcomes. This material is not a recommendation to sell or purchase any investment.

The information contained herein is for general guidance only. It is the responsibility of any person or persons in possession of this information to inform themselves of, and to observe, all applicable laws and regulations of any relevant jurisdiction. The information contained herein does not constitute an offer or solicitation to any person in any jurisdiction in which such offer or solicitation is not authorised or to any person to whom it would be unlawful to make such offer or solicitation.

In Europe, this document is issued by Aviva Investors Luxembourg S.A. Registered Office: 2 rue du Fort Bourbon, 1st Floor, 1249 Luxembourg. Supervised by Commission de Surveillance du Secteur Financier. An Aviva company. In the UK, this document is by Aviva Investors Global Services Limited. Registered in England No. 1151805. Registered Office: 80 Fenchurch Street, London, EC3M 4AE. Authorised and regulated by the Financial Conduct Authority. Firm Reference No. 119178. In Switzerland, this document is issued by Aviva Investors Schweiz GmbH.

In Singapore, this material is being circulated by way of an arrangement with Aviva Investors Asia Pte. Limited (AIAPL) for distribution to institutional investors only. Please note that AIAPL does not provide any independent research or analysis in the substance or preparation of this material. Recipients of this material are to contact AIAPL in respect of any matters arising from, or in connection with, this material. AIAPL, a company incorporated under the laws of Singapore with registration number 200813519W, holds a valid Capital Markets Services Licence to carry out fund management activities issued under the Securities and Futures Act (Singapore Statute Cap. 289) and Asian Exempt Financial Adviser for the purposes of the Financial Advisers Act (Singapore Statute Cap.110). Registered Office: 138 Market Street, #05-01 CapitaGreen, Singapore 048946.

In Australia, this material is being circulated by way of an arrangement with Aviva Investors Pacific Pty Ltd (AIPPL) for distribution to wholesale investors only. Please note that AIPPL does not provide any independent research or analysis in the substance or preparation of this material. Recipients of this material are to contact AIPPL in respect of any matters arising from, or in connection with, this material. AIPPL, a company incorporated under the laws of Australia with Australian Business No. 87 153 200 278 and Australian Company No. 153 200 278, holds an Australian Financial Services License (AFSL 411458) issued by the Australian Securities and Investments Commission. Business address: Level 27, 101 Collins Street, Melbourne, VIC 3000, Australia.

The name “Aviva Investors” as used in this material refers to the global organization of affiliated asset management businesses operating under the Aviva Investors name. Each Aviva investors’ affiliate is a subsidiary of Aviva plc, a publicly- traded multi-national financial services company headquartered in the United Kingdom.

Aviva Investors Canada, Inc. (“AIC”) is located in Toronto and is based within the North American region of the global organization of affiliated asset management businesses operating under the Aviva Investors name. AIC is registered with the Ontario Securities Commission as a commodity trading manager, exempt market dealer, portfolio manager and investment fund manager. AIC is also registered as an exempt market dealer and portfolio manager in each province of Canada and may also be registered as an investment fund manager in certain other applicable provinces.

Aviva Investors Americas LLC is a federally registered investment advisor with the U.S. Securities and Exchange Commission. Aviva Investors Americas is also a commodity trading advisor (“CTA”) registered with the Commodity Futures Trading Commission (“CFTC”) and is a member of the National Futures Association (“NFA”). AIA’s Form ADV Part 2A, which provides background information about the firm and its business practices, is available upon written request to: Compliance Department, 225 West Wacker Drive, Suite 2250, Chicago, IL 60606.