Overview
The rates volatility returned in May with 2-year treasuries jumping by 60 bps during the month. While credit conditions continued to deteriorate, the US services sector and labour market continued to do well. The markets are pricing a higher chance of one more 25bp rate hike in June as compared to a pause in June, to be followed by 2 rate cuts by the end of 2023.
Fed Pause: Rationale & Result
The Fed is likely to pause further rate hikes after June, because:
- Inflation is declining
US headline inflation fell to 4.9% in Apr’23 (from 5% in Mar’23) and, due to base effects, is expected to ease to 4%, in the next couple of months;
- Policy rates are at Federal Reserve guidance
The 25-bps hike in May brings the policy rate range to 5.00-5.25%, in line with Fed’s median “dot plot”;
- Tightening of lending standards
As per Fed’s Senior Loan Officer Survey, about 46% of banks tightened lending standards with 62.3% increasing loan spreads. Year-To-Date Commercial & Industrial (C&I) loan growth is just 0.3% y-o-y versus 7.8% in 2022, and YTD Consumer Loans growth is -0.2% versus 4.5% in 2022.
- US Debt Ceiling deal
The US Debt Ceiling deal, likely to be passed by both the US houses this week, would neutralize the huge liquidity surge of c.US$ 700-800 billion (caused by US Treasury drawing down its general account).
Where is the recession?
Historically, economic slowdown manifests in about 18 months from the start of rate hikes and the labor sector slows down in about 6-12 months thereafter.
The US is not yet in economic recession due to strong consumers and robust services demand.
Figure-1: Key contributor for US real GDP growth (ex inventories change
With consumer spending being higher than their income, the COVID-era excess savings will be depleted in the coming months.
The credit card debt has already surged to the pre-COVID trend (see Figure-2), at an interest cost that is almost twice that of the pre-Covid era.
Figure-2: Rising credit card debt boosting consumption
Fed Pause = Tailwind for bonds
Historically a pause in Fed rate hikes has acted as a huge tailwind for bonds, resulting in double-digit returns, especially for Emerging Markets Investment Grade bonds: the home ground of Silverdale Funds.
Figure-3: 12 months average returns after the last four rate hike cycles ended
China: Loss in recovery momentum
China’s recent economic data has disappointed market expectations on reopening-driven growth. Most Chinese property bonds are close to their November 2022 bottom. China’s youth unemployment peaked at 20.4% in April’23, which is impacting consumption and property sales. Chinese central bank (PBOC) is expected to cut rates as soon as June to support growth.
Higher starting yields 🡪 Investor Cushion
Historically, the starting bond yields have been a good indicator of bond returns over the next five years.
Figure-4: Starting YTW vs. next five-years Annualized Returns
Higher starting rates provide a cushion to bondholders in case of spread widening. In case of a mild to deep recession, a likely reduction in interest rates more than compensates for the potential negative impact of bond credit spread widening.
In 40-years’ history of Bloomberg’s US Corporate High Yield Index, the average annualized total return has been 7.7%. Missing the best one month and two months in each of those years would have cut that return to only 3.5% and 0.99%. In summary, it pays to remain invested, rather than time the market.
Figure-5: Strong Returns under different Economic Scenarios
Takeaway
Silverdale Funds are optimally positioned to benefit from the high carry offered by quality bonds. In most of our funds, we are lowering our cost of borrowing by borrowing for a longer tenure than usual. We are also selectively increasing our duration, which will be more visible in the coming month.
The market volatility is masking the much higher quality of Silverdale Bond Fund, which with 78% high-quality Investment Grade bonds has an elevated leveraged YTM of 13.3%, pointing to much higher potential returns. We continue to see strong investor interests. We thank you for your faith in us, which has ensured a steady net positive subscription in 2023.
Silverdale Fixed Maturity Funds (FMPs) have provided circa 0.50% absolute returns in 2023 and are on track for their envisaged returns. We are grateful for your confidence in us.
DISCLAIMER
THIS COMMENTARY IS AN INTEGRAL PART OF AND SHOULD BE READ ALONG WITH THE FUND FACTSHEET FOR MAY 2023. This document is written for the benefit of and is being communicated exclusively to Accredited Investors or Institutional Investors as defined under the Securities and Futures Act (Cap. 289) of Singapore. The above commentary does not provide a complete analysis of every material fact regarding the market, industry, security, portfolio, or any Silverdale fund. It is not a recommendation to buy or sell any security nor an investment advice. The portfolio holdings, opinions and information may change without notice and the actual results may differ from the said opinions and estimates. The contents of this document, including any narrative, does not constitute an offer to sell or a solicitation of any offer to buy the units or any Sub-Fund or class of the Silverdale Fund VCC (the “Fund”) or any of the funds managed or advised by Silverdale Capital Pte Ltd., and is strictly for educational purpose only. The distribution of the shares of the Fund may be restricted in certain jurisdictions. It is the responsibility of the person or persons in possession of this communication to inform themselves of, and to observe all such restrictions, all applicable laws, and regulations of the relevant jurisdiction, including of any applicable legal requirements, exchange control regulations and taxes in the countries of their respective citizenship, residence, and domicile. Any subscription for units or shares must be made solely based on the Fund’s private placement memorandum, applicable class supplement) and Subscription Documents (together “the Offering Documents”). Past performance is not an indicator of future performance. The Fund uses leverage and invests in financial derivative instruments. Please refer to the Offering Documents for Risk Factors. Nothing in this document is intended to constitute legal, tax, securities or investment advice or opinion regarding the appropriateness of any investment, or a solicitation for any product or service. Please seek opinion from an independent professional adviser before taking any decision based on this document.