Liontrust Strategic Bond Fund

With the debt ceiling suspended until January 2025, bond market attention has shifted back to economic fundamentals. Starting in the US where inflation is too high but heading in the right direction, consumer price inflation (CPI) data snuck in below expectations at 4.9% (consensus 5.0%, prior 5.0%) with core CPI meeting expectations of a small decrease at 5.5% (consensus 5.5%, prior 5.6%). Goods prices have been surprisingly strong in the first quarter of 2023. In the April data (released in May) there was another upside surprise, but this was caused entirely by used car prices which jumped up by 4.4% during the month; I expect this erratic item to fall back down again soon. Excluding used car prices, core goods prices were flat on the month; I attribute this to the continued easing in supply side constraints coupled with reduced PPI (producer price inflation), and a retrenchment in some excess profit margins within the supply chain. I expect goods prices to re-enter disinflationary territory in the second half of the year.  Within services. the monthly rent figure – rents and owners’ equivalent rents – was around 0.5% again at 0.56% and 0.54% respectively; this is below the run rate of 0.7% – 0.8% seen around the turn of the year. One of our key messages on inflation is the methodological lag in these shelter items; it is reassuring to see the inflationary pace start to decline and there will inevitably be a lot more to come in the second half of 2023. Most importantly, core services ex-housing was only up 0.1% in the month (the lowest since July 2022); this is likely to be a little higher over the coming months, but the huge improvement will be a relief for the Fed. It is core services ex-housing that is most correlated to nominal wage inflation, hence why Powell et al have been so keen to see this measure, one of the ones they can easily exert influence over with monetary policy, decrease. The detail was supportive of a declining trajectory in inflation.

Unemployment tends to occur very late into the economic cycle and presently the labour market remains remarkably robust. The JOLTS data was strong with openings back above 10 million at 10,103k (consensus 9,400k, prior 9,745k). The only silver lining was the quits rate falling again, ticking down to 2.4%. Headline nonfarm payrolls were 339k (consensus 195k, prior 294k) with private payrolls of 283k (consensus 165k, prior 253k); those are the bits that the bit that the Fed and bond market won’t like. However, there was also some good news for bonds in the data. Average hourly earnings decreased to 4.3% (consensus 4.4%, prior 4.4%), but do note this does not adjust for the mix effect; weekly hours reduced to 34.3 (consensus 34.4, prior 34.4).  Importantly, the unemployment rate overshot at 3.7% (consensus 3.5%, prior 3.4%), with underemployment ticking up 0.1% to 6.7%.  Although the payroll figures were slightly bearish for bonds, I do not believe the strength is uniform enough to persuade undecided Fed voters to turn hawkish. A pause (or “skip” as it is now often being called) in rate hikes at the June meeting is still the most likely scenario. The market is pricing a 40% probability of a 25bps hike in June. Continued strength in data could tip the Fed into hiking again in July (hence the skip language), the market is pricing in over 80% probability of an increase. 

Eurozone inflation figures for May are also a little encouraging. Inflation figures undershot expectations with CPI at 6.1% (consensus 6.3%, prior 7.0%) and core CPI 5.3% (consensus 5.5%, prior 5.6%). Energy inflation was -2.2% in May, taking the annual figure back into negative territory at -1.7%. Inflation in food, alcohol and tobacco remains high but has come off its top and should start to fall faster over the coming months. Core goods continue to see inflation fade, dropping by 0.4% to a rate of 5.8%. The all-important services inflation also reduced, this time by 0.2% to 5.0%. This was slightly flattered by the new German transport subsidies; the subsidies are not as large as last year so base effects mean services inflation will rise a little over the summer, but the underlying trend now seems to have stabilised. The trajectory of the overall figures will please the ECB, but the absolute level is still too high for victory over inflation to be declared. My central case of the ECB undertaking two more 25bps hikes to reach a terminal rate of 3.75% remains the same, but the right hand tail risk of further tightening beyond this has slimmed significantly post these inflationary figures.

Finally, the UK inflation data was dreadful, pretty much defining “persistent pressures” and will force the Bank of England to overshoot further in its tightening cycle. Headline CPI fell to 8.7% (consensus 8.2%, prior 10.1%) but core CPI increased to 6.8% (consensus 6.2%, prior 6.2%). The fall in the headline figure into single digit territory is about the only good news. The strength in core inflation figures was alarming; Gilts have hugely underperformed other developed markets during May as a result of this.

Electricity and gas prices knocked 1.4% off annual inflation, largely as last April’s rise dropped out of the 12-month figure; it still added 1.0% to annual inflation. Given the decrease in the Ofgem price cap announced during May, energy’s contribution should fall by around another 0.8% in July.  Food inflation was down 0.1% but still at very high levels, with 19.2% in the year to March 2023, compared to 19.1% in the year to April 2023; disinflation should start soon assuming wholesale price decreases are passed through to the consumer. April’s CPI figures include a number of items (rents, phone bills, etc) that are linked through CPI clauses to past inflation, the upside surprises were in other goods and services. Within goods, one of the highlights/lowlights was used car prices rising, but the overall upside was widespread. Similarly, services witnessed an increase in inflation from 6.7% to 6.9%. This latter measure is the one that will concern the Bank of England most. It is the one that monetary policy should be able to exert significant influence over. As a reminder, the MPC’s latest statement included the line “…If there were to be evidence of more persistent [inflationary] pressures, then further tightening in monetary policy would be required”. These figures definitely showed persistent inflationary pressures so a June rate rise should be a certainty; the only debate is whether they revert back to a 50bps increment (I don’t think they will, but never have high confidence in Bailey’s guidance). The market is now pricing for 100bps of cumulative further tightening to take peak rates to 5.50% in November. 

I do think a lot of the inflationary problems we are now seeing are lagged effects of previously inappropriately loose monetary policy compounding the impulse created by supply chain problems. The restrictive rate environment now in place will lead to falls in inflation; once a recession starts the inflationary fall will accelerate.  Unfortunately, previous mistakes are going to be compounded by the Bank of England being forced into overshooting on the upside, albeit I doubt they will reach 5.50% base rates. In my opinion this represents an opportunity to buy UK duration exposure, but given sticky core inflation and an unpredictable central bank (and in October 2022 reckless Government), it will be a volatile path to lower long-term yields.