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Sterling Credit Short Duration strategy - August 2023

  • 01 September 2023 (5 min read)

UK gilt yields fall as UK inflation surprises to the downside

  • Sterling investment grade credit spreads tightened on the back of receding fears of recession in the US and Europe
  • UK gilt yields fell, with the front-end significantly outperforming, as UK inflation surprised to the downside
  • We continued to reduce our exposure to BBB-rated debt

What’s happening?

Sterling investment grade credit spreads tightened on the back of positive economic data, including receding fears of recession in the US and Europe, further stimulus measures in China, a positive earnings season, and falling inflation.

The US Federal Reserve resumed interest rate hikes in July after pausing in June, increasing by 0.25% to a range of 5.25% to 5.50%. Meanwhile, the European Central Bank delivered another 0.25% rate rise to 3.75%. There was no Bank of England monetary decision in July but markets had priced in a 0.25% rise in August, potentially taking the cost of borrowing to 5.25%.

Yields on UK gilts fell, with the front-end significantly outperforming, as UK inflation for June surprised to the downside at 7.9%, below consensus estimates of an easing to 8.2%. As a result, UK gilts substantially outperformed US treasuries and German bunds.

Portfolio positioning and performance

Sterling investment grade primary issuance was extremely low in July, falling to just £0.7bn. As such, we did not participate in any new issues. We added to UK gilts to benefit from the fall in yields at the front-end following the downside surprise to UK inflation. As a result, our exposure to sovereign bonds increased by 2% to 12% while our exposure to BBB-rated bonds decreased by 2% to 46%.

Outlook

The macroeconomic outlook remains very uncertain given high (but falling) inflation, rising (but peaking) interest rates, slowing (but resilient so far) growth and tighter lending conditions. As such, we expect market conditions to remain very volatile with an increased likelihood of a global recession late this year or early next year as central banks’ ability to cut interest rates to support growth is curtailed by still elevated inflation.

With valuations looking fair to expensive, we plan to continue reducing the level of credit risk gradually so that we could benefit from a potential widening in credit spreads late this year or early next year by re-risking the portfolio at much better levels.

 

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