Ardea Real Outcome Fund (HOW0098AU) Report & Performance

Fund performance for the month of July was +0.9%.

July was a relatively quieter month for bonds markets, while risk assets continued to rally. Both US and Australian shares rose strongly, with a 3% increase. Year-to-date the S&P500 is up 19.5%. These gains were largely driven by softer-than-expected inflation data in the US and Australia, which led to the belief that the need for further rate hikes might be reduced. Consequently, the consensus macro narrative now revolves around the idea that rate hikes are nearing completion, and the risk of a recession has been averted. The risk to this ‘goldilocks consensus’ scenario is that central banks over tighten and then need to cut quicker as economies weaken.

The U.S. Federal Reserve indicated that it no longer expects a recession, and with slowing inflation, steady unemployment, GDP growth and consumer spending encourage investors that a soft landing was possible. In the bond market, 10-year Australian government bonds ended the month slightly higher at 4.06% and remained within the range observed since mid-last year (3.3%- 4.1%). In contrast, US 10-year yields increased 16bpts to 3.97%, nearing a 15-year high. The US Treasury is planning to issue more than USD 1 trillion of bonds and bills in the coming three months, while the supply of government bonds in the UK and Europe is also expected to increase dramatically in the near term. This situation is exasperated in the United Kingdom where the Bank of England is actively scaling back the size of its Gilt portfolio (UK government bonds).

The Federal Open Market Committee (FOMC) and European Central Bank (ECB) both raised rates by 25 basis points despite the improving outlook for inflation, the market is divided on whether there will a need for further rate increases. Any future rate increases will be driven by economic data, as the Fed and ECB closely monitor inflation to ensure it stays on track to reach their targets. The Bank of England (BOE) did not meet in July, but it is expected to increase rates at the early August meeting.

Fund performance for the month of June was +0.15% (after fees).

In a short span of time, markets have made significant progress. Risk assets performed well in June, with the ASX200 index gaining 1.6%. This surge led many equity indices to reach their highest levels in over a year, with the ASX200 up 9.7%. Volatility measures continued to decrease, reaching levels similar to those before the COVID-19 pandemic. This recovery is remarkable, especially considering the pessimism experienced in Q1 when concerns about US bank failures and an impending recession in major economies prevailed. The recent optimism is backed by the resilience shown in economic data during Q2, particularly in the US.

Meanwhile, the aggressive rate hike cycle is set to stay higher for longer as inflation continues to remain stubbornly high. Apart from the Bank of Japan, all major central banks either increased rates in June or strongly indicated their intention to do so in the coming months. The US Federal Reserve decided to pause its tightening cycle after implementing a cumulative 500 basis points of rate increases. Federal Reserve Chair Powell acknowledged the extensive ground covered so far but pointed out that the full impact of these tightening measures is yet to be fully realised. He also projected two more quarter percentage point increases may be required before the end of the year. The minutes from the Federal Open Market Committee (FOMC) stressed that inflation levels remain elevated. In contrast, the Reserve Bank of New Zealand (RBNZ) signalled that it is likely to have completed its tightening cycle after raising the cash rate to its highest level in 14 years, reaching 5.5%.

In Australia, the labour market showed strength with a decrease in unemployment rate, robust employment growth, and record-high participation rates. The RBA surprised the market with a rate hike, acknowledging the increase in upside risks to the inflation outlook. The RBA emphasised the importance of improved productivity to prevent wages from becoming inflationary. It also hinted at the possibility of further monetary policy tightening to ensure inflation returns to the target range within a reasonable timeframe. Market economists are predicting an additional 2 to 3 rate hikes, which would bring the terminal rate to a range of 4.60% to 4.85%.

Performance for the month of May was -0.17%.

Market sentiment was influenced by ongoing negotiations regarding the US debt ceiling, which had a more pronounced impact in the latter half of the month. Consequently, global bond yields experienced an upward pressure throughout the month. By the end of the month, an initial agreement on the US debt ceiling was reached, although it still requires progression through the House rules committee, the House of Representatives, and the Senate for approval. This development brought about a slightly more positive outlook, resulting in longer-term yields declining marginally towards the end of the month with softer CPI data in Europe and weaker China PMI data also contributing. Once the debt ceiling is raised, it is anticipated that the US Treasury will issue a substantial amount of bills, totalling $1.2+ trillion, by the end of the year to replenish its cash balance. European Central Bank (ECB), Bank of England (BOE), and Reserve Bank of New Zealand (RBNZ) all implemented 25 basis point rate hikes. The level of overall macro uncertainty remains high and bond markets continue to swing dramatically between divergent states of the world, from recession and rate cuts to high inflation and higher rates for longer. The move higher in yields has bond market indices delivering negative returns for the month.

Overall, bond yields exhibited a broader range of fluctuations in May compared to April, but remained within the boundaries observed in March (both US Treasury and Australian 10-year yields fluctuated within a 56 basis point range, while Australian 3-year yields experienced a wider 69 basis point range). Initially, yields moved lower during the month as concerns eased regarding the US regional bank sector. However, economic data releases from mid-month onwards did not support further decreases in rates, compounded by concerns surrounding the debt ceiling. Examples of yield moves include US Treasury 10-year yields increasing by 22 basis points, to close at 3.65%, and US Treasury 2-year yields concluding the month with a 39 basis point increase, settling at 4.40%. Australian 3-year yields increased by 37 basis points, closing at 3.37%, while Australian 10-year yields rose by 27 basis points, closing at 3.60%.

Performance for the month of April was -0.46%.

April was less eventful for markets following the extreme moves in March with volatility easing although by month end the First Republic Bank in the US was taken over by the Federal Deposit Insurance Corporation and then most of its assets sold to JPMorgan Chase, this was the third major bank failure in the U.S. in less than two months and is likely to keep US regional banks in the headlines for the month ahead. The RBA left the cash rate unchanged at 3.60% which was its first pause in rate increases since it started increasing rates in May 2022, delivering a cumulative increases of 3½ percentage points. The BoC also paused whist the RBNZ and Riksbank both increased rates. The US Fed and the ECB did not meet in April however both meet in the first week of May and both are expected to increase their cash rate.

Moves in rates markets were more restrained in April, for example in Australia 10y bond futures, 3.56%, traded in a 41bp range v 84bp in March, whilst 3years, 2.98%, traded in a 46bp range v 106bps in March. AUD swap spreads narrowed over the month and volatility declined in rates markets as did equity market volatility which closed at its lowest level for over a year.

There were two key domestic economic releases, inflation data, the headline annual inflation rate came in 7% y/y down from 7.8% y/y at the Dec quarter but above consensus forecasts and remains stubbornly high, the trimmed mean printed at 6.6%. The second was employment data which was stronger than forecast with the unemployment rate printing at 3.5%. In other markets US payrolls data was better than expected while UK inflation was higher than anticipated driven by rising food costs keeping the inflation rate above 10%.

Following the rate hike pause in April the RBA has surprised the markets on 2 May by again tightening rates by a further 0.25% to 3.85% sighting concern over services side inflation, a tight labour market and wages growth. Market participants are now looking for further increases over coming months as the RBA remains committed to return inflation to target which may mean the policy cycle could remain higher for longer.

Performance for the month of March was +3.4% (after fees).

March was eventful in markets. The collapse of SVB, forced merger between Credit Suisse and UBS and pressure on other banks was a major shock for investors. Volatility surged – most notably in interest rate markets and US regional and some European bank assets. While some calm returned by month-end, markets remained priced for a significantly lower path for rates, reflecting expectations that credit tightening will serve as a substitute for further rate hikes and that something else will break following the relentless rate hikes delivered over the last year. This is a big change from early in the month, when investors feared a higher-for-longer rate scenario, as inflation remains well above central bank comfort levels. (See our latest note for more detail on recent rates volatility).

The moves have been especially violent at the front end of the US curve. Of note:

• Measures of short-dated US rates volatility eclipsed 2008 highs, as the market moved from pricing nearly 100bp of Fed rate hikes to as much as 80bp of rate cuts, despite a Fed hike in the month.

• The UST 2y yield tracked a 160bp range, registered one of the biggest ever 3 day moves and the UST 2s10s curve steepened the most in a single day since the early 1980s.

• The ECB and BoE also hiked rates in March, yet these markets, along with others such as AUD and CAD, saw big falls in forward interest rate pricing.

The Fund’s RV strategy delivered outsized gains over the month, particularly in the USD market. The Fund is positioned across a large number of RV trades, a subset of which targets micro yield curve anomalies with futures contracts on short-dated US interest rates. The large movements in short-dated USD rates benefited these positions.

Gains were accelerated by the integration of options on US futures with less than one year to maturity, within yield curve RV strategies. The decision to buy options reflects a view on the RV attributes of the options themselves and the risk balancing benefits that come with blending options into RV strategies.

Performance for the month of February was 1.22% (after fees).

After a strong start to the year for most asset classes, markets reversed course in February. Sovereign bonds, credit and equities delivered negative returns. The broad macro narrative abruptly shifted from disinflation and peak rates to a higher for longer view on rates following upside surprises to inflation, jobs and high frequency global growth data. Central banks have reinforced hawkish rhetoric. The subsequent sharp repricing higher of terminal policy rates has taken short term bond yields to new cycle highs, flattening yield curves.

Against this challenging market backdrop for conventional fixed income, the Fund’s RV strategy delivered positive performance in February. Elevated macro uncertainty over the path for interest rates is creating new RV opportunities for the Fund to target through increased micro distortions in the shapes of yield curves. We have recently added positions in interest rate swaps in the USD and EUR markets to target these mispricings. Bond supply/demand dynamics are also presenting new opportunities as markets adjust to lower central bank bond holdings and high issuance levels, particularly in the EUR and GBP markets.

The drivers of performance for the Fund are summarised by broad risk factors in the attribution table. These risk factors capture a large number of underlying trades across global interest rate markets and as such, there is no single position that explains performance. We outline a few themes impacting the attribution.

Bond vs Derivative exposures added value, led by gains in the AUD market. The Fund holds government and semi-government bonds across the curve, hedged with swaps and futures. For example, within the AUD market, the Fund benefited from outperformance in shorter maturity inflation linked bonds and 15-30y nominal government bonds relative to swaps.. Positions in 12-14y semi-government bonds also outperformed swaps. These are a relatively cheap sector within semi yield curves. Positions in the GBP market also added value, as a short in relatively expensive 30y Gilts underperformed an offsetting long position in swaps (the Fund is also positioned long in shorter maturities to capture relatively cheap Gilts). A small detraction came from long and short curve positions in long-dated French government bonds.