Investment Policy Statement - A monthly review of the markets
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January 2022
Investment Policy
Statement
A monthly review of the markets
In our final issue of 2021, we outlined three key questions that
carried significant weight in determining the course of US Federal
Reserve (Fed) policy. Importantly, these questions around the state
of the labor market and inflation were posed within the context of
an economic landscape that is quite different from the past several
decades. The Fed’s latest communications following the rate-
setting meeting on 26 January clearly indicate that those pressing
questions have been sufficiently answered -- at least in the short
term -- and serve as impetus for action. It now looks likely that the
Fed will increase rates four times over the course of 2022, starting
at the March Federal Open Market Committee (FOMC) meeting.
Along with that, balance sheet runoff will start, probably sometime
in the second half of the year.
The Fed Doesn’t Have All the The first question we highlighted was can the economy return to
Answers It Needs Yet, But It Does the 2019 pre-pandemic labor market? The Fed has deliberately
chosen to not fully answer that question in the near-term, but
Have Enough to Move instead to look at a somewhat more nuanced version: can the
economy get to the pre-pandemic labor market soon? Their
“Those who cannot change their minds cannot change conclusion was no, not quite. Over the second half of 2021, the
labor force participation (LPF) rate remained relatively depressed.
anything.”
Even with the ongoing rollout of vaccinations and the ending
– George Bernard Shaw, Irish playwright of enhanced unemployment insurance, LFP remained relatively
sluggish. A substantial chunk of workers did not return to the labor
market and retirements ran relatively high, though the ongoing
aging of the population complicates interpretation. As we’ve noted
in the past, a relatively easy way to cut through some of these issues
is to look at the prime-age employment-population ratio. Prior to
the pandemic, that ratio had finally recovered from the financial
crisis and was around 80%. This metric did rebound strongly in Q4
rising nearly a percentage point. Still, at 79.0%, it remains notably
below 80%. The Fed has, however, decided that with the lack of
a robust LPF recovery, the economy cannot get back to 80% on
employment to population right now. The right now caveat matters
as the Fed appears open to the possibility that the desired rebound
can be achieved over time. They appear willing to entertain the
possibility that a continued strong labor market, when combined
with the anticipated fading of Covid, will pull workers back into the
workforce, but that the adjustment will take some time.
Stone Harbor Investment Partners | January 2022 Investment Policy Statement 1Figure 1: Fed Will Soon Be Able to Credibly Claim Figure 2: GDP Potentially Above Potential
Maximum Employment
% % 20500
12 84
20000
82
8 19500
80 19000
4
18500
78
0 18000
76 17500
-4
17000
74
16500
-8
72
16000
6M Change in Prime Age Employment-Population Ratio
-12 15500
Prime Age Employment-Population Ratio 70
2018 - 2018 - 2019 - 2019 - 2019 - 2019 - 2020 - 2020 - 2020 - 2020 - 2021 - 2021 - 2021 - 2021 -
Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4
Constant = 79.5
-16 68 Actual Growth Since Pandemic's Start at 1.75%
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 Growth Since Pandemic's Start at 1.25% Fed's Dec 2019 Projection
As of 7 January 2022 As of 30 December 2021
Sources: Bureau of Labor Statistics, Haver Analytics Sources: Bureau of Economic Analysis, Stone Harbor Investment Partners, LLC
The second, and closely related, question was how tight is the GDP growth, that extra 1½pp could be the difference between
labor market right now and for how long will it remain that output above potential and below potential. If potential growth
way? The answer to this question was clear; the labor market is during the pandemic was 1-¼%, then that is the case. Note
tight right now. Indeed, with the unemployment rate at under however, that if potential was higher, say at 1-¾%, then output
4%, we expect the Fed to essentially declare victory on reaching would still be below potential. The more rapid growth led to
maximum employment, again in the short-term. That is important associated labor market improvement, which was also much larger
because the Fed’s guidance on interest rates stated that rates than the Fed had expected; instead of a 5.0% unemployment rate,
would remain at the effective lower bound until the economy we saw 3.9%. Counterfactuals are always difficult, but it’s very
reached maximum employment, along with some inflation likely inflation would probably be more quiescent if growth had
conditions. The Fed has already noted the inflation conditions been 1.3pp lower; the strength of the rebound is a key factor in
have been met, so attaining maximum employment allows them to understanding shifting policy, in our view.
adjust rates higher.
The additional information we now have, both on the economy
An important consequence is that as the economy moves away and the Fed’s reaction, has led us to revamp our macroeconomic
from the effective lower bound, the underlying policy regime scenarios. Our baseline scenario now assumes that the Fed will
shifts. At that lower bound, the Fed often had to operate through begin hiking interest rates in March, with three additional increases
commitments to future actions—promising to keep rates low into this year (for a total of four) and that the Fed will start allowing
the future—to effect market rates. Saying that they have fulfilled balance sheet runoff in the second half of the year. The latest
their commitment in a credible fashion allows them to preserve the Employment Cost Index data, which remains elevated, combined
ability to use commitments in the future. But we are now entering with the Personal Consumption Expenditures report provide further
a different regime, one where they can use actual actions rather support to the Fed’s preference for starting rate hikes sooner
than commitments to affect rates. If growth is slower, then they can than later. Our baseline has growth slowing notably more than
adjust. If inflation slows more, then they can adjust. If LFP starts to consensus.
move higher, they can also adjust. Beyond the immediate incoming
data, which will reflect temporary distortions from Omicron that We remain cognizant, though, that more rapid growth would
the Fed will likely look through, incoming data on the underlying translate into more rate hikes: the commitment free policy
trajectory of the economy will dictate the path of Fed policy. we mentioned earlier. We have incorporated a scenario of an
inflationary boom, where growth slows less than in our central
The final question we flagged was will inflation ultimately prove expectation and, as a result, inflation remains higher due to that
to be transitory in nature? The answer to this question is not rapid growth. We assign a probability of 15% to this scenario.
yet obvious, but the Fed has decided that it can no longer wait, We also added a scenario of a US-led policy error, to which we
especially in light of the first two answers. Both Fed Chair Jerome assign a probability of 10%. Here the Fed tightens aggressively
Powell’s comments and most recent Summary of Economic into a slowing economy and moderating inflation. As a result,
Projections (SEP) still point to inflation moderation over the course both inflation and growth slow considerably, and the recovery
of the year, despite sustained higher inflation readings and a stalls. China remains a concern to us, in particular the liquidity
prolonged supply chain pressures. While the Fed’s expectation crisis among private real estate developers. The push to force
remains that the trend will reverse, the Fed has decided that it deleveraging has already significantly dampened real estate sales
needs to respond now. and construction activity. The risk is that the slump accelerates and
policy support remains too small and/or comes too late. Moreover,
Fundamentally, GDP in 2021 grew more rapidly than any year consumers are already rather cautious in light of continued tight
since 1984. Q4/Q4 growth was 5.5%, or about 2pp faster than any Covid policies and given the size of the real estate sector, a deeper
other year over the past two decades. The December 2020 SEP real estate crisis could have a significant impact that would spill
had projected 2021 Q4/Q4 growth at 4.2% growth, so growth was over globally. Our assessment of the probability of a disruptive
nearly 1½pp higher than the Fed expected. As figure 2 illustrates, China-led slowing has moved up somewhat to 15%.
depending on exactly what assumptions you make about potential
Stone Harbor Investment Partners | January 2022 Investment Policy Statement 2MACRO RISK SCENARIO ASSUMPTIONS AND MARKET OUTLOOK¹
• Omicron slows recovery in Q1, though by somewhat less than delta’s drag.
• The very high infectiousness of omicron means that close to entire population in most countries has been exposed and
recovered or vaccinated by spring. Pandemic starts to fade into background as behavior changes and growth-retarding
measures are abandoned.
Recovery Continues, • By Q3 most economies are operating along pre-pandemic norms.
Though Pace • Policy of local lockdowns remains in place for China, and continues to impact economic behavior.
• US/China tensions remain cooler, but do not return to pre-Trump status quo.
Moderates, as COVID • China growth somewhat softer than consensus.
Fades Over 2022 • Core PCE remains elevated well into 2022. Some of the increase comes from still-snarled supply chains, which start to
(60%) normalize in the summer combined with rotation of demand back to services. But the underlying inflation run-rate has
moved higher.
• Fed hikes rates 4 times in 2022, starting in March. Balance sheet runoff commences in H2.
• ECB winds down asset purchases over 2022; rate hikes priced for 2023.
• Rate hikes continue across EM, with the exception of China.
• Oil gradually returns to ~$70/barrel WTI, Brent ~$75.
• Challenged by high inflation, the Fed ends asset purchases earlier than expected and embarks on a course of more
frequent rate subsequently. Balance sheet runoff starts in Q2. Financial conditions tighten materially, but the Fed
US-Led Policy Error persists.
(10%) • Build Back Better fails. When combined with ongoing roll-off of 2021 stimulus, fiscal policy is very contractionary.
• The combination of rapid fiscal and monetary tightening materially slows the US economy. Growth fades rapidly: to
below 2% into H2.
• With slower activity and sluggish consumer demand inflation moderates rapidly, dipping toward target by year-end.
• Slower US growth spills over into other DM and EM economies, though they perform relatively better than the US.
• Curve inverts as the market prices in the reversal of some rate increases. In late 2022 Fed stops shrinking the balance
sheet.
• ECB asset purchases continue and rate hikes appear far off. Pace of rate increases slows in EM.
• Oil: WTI at ~$55/barrel; Brent ~$60/barrel.
• Asset sales by distressed Chinese developers trigger price declines.
• Buyers lose confidence and fail to step in, triggering deeper liquidity problems for developers, deeper price cuts, and
sharp drop in construction activity.
Weaker China • China continues attempting to contain COVID by using very aggressive measures, now under the “dynamic clearing”
label.
Growth from Combo • The combination slows China’s economy sharply. Move away from using regulatory policy in stabilization makes
of Real Estate Bust adjustment harder.
& Continued COVID • Growth slump spreads globally as China troubles coincide with the withdrawal of fiscal stimulus in DMs and some EMs,
though China most affected.
Lockdowns (15%) • Inflation mixed. Relief on headline measures as lower Chinese demand pulls down energy prices, but supply chain
issues remain problematic with rolling shutdowns of different regions.
• Fed raises interest rates, but with slower growth and slow enough inflation pauses into H2-2022. No balance sheet
shrinkage. ECB also extends guidance that rates will remain fixed.
• Trade tensions persist, as in the base case.
• Dollar sees upward pressure from renewed flight to safety.
• Oil prices hit by lower growth: ~$55/barrel for WTI; Brent ~$60.
• Growth remains very strong, with omicron only causing a brief drag. Services demand rebounds while goods demand
remains robust. Output moves clearly above the pre-pandemic trend.
• Supply chain issues do not resolve and price increases remain elevated. Facing tight labor supply, firms continue to bid
Inflationary Boom up wages attempting to pull workers off the sidelines.
(15%) • Recent inflation surprises prove durable: there is no reversion downward in sequential rates. Wage inflation flows into
price inflation through housing as CPI rent and OER are high.
• Core inflation remains meaningfully elevated into mid-2022. Inflation also drifts higher in other DMs.
• Fed immediately transitions to rate hikes and indicates a steeper path ahead. Other central banks also indicate sooner
and more rapid rate increases.
• Rates move sharply higher along the curve.
• Interest rate sensitive sectors start to drag, but that is offset in the broader economy by growth elsewhere.
• Oil prices rise further with growth and inflation: WTI to $100/barrel, Brent $105/barrel.
Weaker China Growth from
Recovery Continues, Though
Combo of Real Estate Bust &
Pace Moderates, as COVID US-Led Policy Error (10%) Inflationary Boom (15%)
Continued COVID Lockdowns
Fades Over 2022 (60%)
(15%)
US Real 4Q GDP (%) 3.25 1.50 2.50 4.50
Fed Funds (%) 1.13 1.13 0.63 1.63
US Core PCE (%) 2.60 2.00 2.25 3.25
2yr Treasury (%) 1.50 1.00 0.90 2.25
10yr Treasury (%) 2.25 1.25 1.90 3.00
10yr Bund (%) 0.10 -0.50 -0.40 1.00
China 4Q GDP (%) 5.00 4.00 2.50 5.50
EM 4Q GDP (%) 4.00 2.50 2.00 4.75
¹Forecast Period: Next 12 months. Source: Stone Harbor.
Stone Harbor Investment Partners | January 2022 Investment Policy Statement 3MULTI-ASSET CREDIT TARGET ALLOCATIONS (%) SINCE INCEPTION &
RECENT ALLOCATION CHANGES2
40 Latest Allocation Changes
Month Change (%)
35
31.0 EM Local Currency Dec-Jan 2021 +2.5
30
EM Hard Currency Nov-Dec 2021 +5.0
25
EM Corporates May-June 2018 +1.5
20
17.0 Euro High Yield May-June 2020 -2.5
15 15.0 14.0
US High Yield June-July 2021 +4.0
10
7.5
Loans Jan-Feb 2021 +1.5
5 5.5 6.0
4.0 Securitized Mar-April 2019 +1.0
0.0
0 IG Corporate June-July 2021 -2.0
Treasuries/Cash Nov-Dec 2021 -5.0
High/Low Range Current
2
Since Inception: September 2013. Stone Harbor Multi-Asset Credit Representative
Target Allocation as of 31 December 2021. Actual allocations within any account
may be significantly different from the target allocations shown here. For illustrative
purposes only.
DECEMBER CREDIT MARKET TOTAL RETURNS & ATTRIBUTION
US High Yield EM Hard Loans EM Local EM Corp Euro High Yield IG Corporate
Total Return 1.88 1.40 0.64 1.56 0.40 1.01 -0.06
Duration -0.35 -0.57 -0.08 -0.38 -0.39 -0.58 -0.65
(Returns from Interest Rates %)
Credit Beta 2.23 1.97 0.72 1.94 0.79 1.59 0.59
(Returns from Spreads %)
Month Ended 31 December 2021. Performance reflects representative asset class benchmarks.HY: ICE BofAML US High Yield Constrained Index; EMD: J.P. Morgan
EMBI Global Diversified; EMDLC: J.P. Morgan GBI-EM Global Diversified; EMDCR: J.P. Morgan Corporate Emerging Markets Bond Index Broad Diversified;
EUR HY: ICE BofAML European Currency High Yield 2% Constrained Ex Financial; IG Corp: Bloomberg Barclays Global Agg Corporate Index; Loans: S&P/LSTA
Leveraged Loan Index; Past performance is not a guarantee of future results. Returns are shown gross of fees. For illustrative purposes only.
Stone Harbor Investment Partners | January 2022 Investment Policy Statement 4STONE HARBOR INVESTMENT PARTNERS
• Institutional fixed income investment firm focused on credit risk strategies and asset allocation.
• 100% employee-owned
• Over 30-year performance history
• Offices in New York, London, and Singapore.
• Effective January 1, 2022, Stone Harbor Investment Partners is an affiliate of Virtus Investment Partners
Stone Harbor Investment Partners, LLC manages institutional clients’ assets across a range of investment products including multi-sector credit, emerging markets
debt, core fixed income, securitized, high yield, and bank loan strategies. Across all strategies, we seek to generate attractive risk-adjusted returns through a
disciplined process of fundamental credit analysis complemented by solid portfolio management skills and sound risk management. Experience, teamwork and
dedicated client service - the cornerstones of our success - help us achieve sustainable results.
Indices referred to herein are broad-based securities market indices. Broad-based securities indices are unmanaged and are not subject to fees and expenses
typically associated with managed accounts or investment funds. Investments cannot be made directly in an index.
Index Definitions
The J.P. Morgan CEMBI Broad Diversified (CEMBI Broad Diversified) tracks total returns of U.S. dollar-denominated debt instruments issued by corporate entities
in emerging market countries and consists of an investable universe of corporate bonds. The minimum amount outstanding required is $350 mm for the CEMBI
Broad Diversified. The CEMBI Broad Diversified limits the weights of those index countries with larger corporate debt stocks by only including a specified portion
of these countries’ eligible current face amounts of debt outstanding.
The J.P. Morgan EMBI Global Diversified (EMBI Global Diversified) limits the weights of those index countries with larger debt stocks by only including specified
portions of these countries’ eligible current face amounts outstanding. The countries covered in the EMBI Global Diversified are identical to those covered by the
EMBI Global.
The J.P. Morgan GBI-EM Global Diversified (GBI EM Global Diversified) consists of regularly traded, liquid fixed-rate, domestic currency government bonds to
which international investors can gain exposure. The weightings among the countries are more evenly distributed within this index.
The ICE BofAML European Currency Non-Financial High Yield 2% Constrained Index contains all non-Financial securities in The ICE BofAML European Currency
High Yield Index but caps issuer exposure at 2%. Index constituents are capitalization-weighted, based on their current amount outstanding, provided the total
allocation to an individual issuer does not exceed 2%. Issuers that exceed the limit are reduced to 2% and the face value of each of their bonds is adjusted on a
pro-rata basis. Similarly, the face values of bonds of all other issuers that fall below the 2% cap are increased on a pro-rata basis.
The ICE BofAML U.S. High Yield Constrained Index (HUC0) contains all securities in ICE BofAML U.S. High Yield Index but caps issuer exposure at 2%. Index
constituents are capitalization-weighted, based on their current amount outstanding, provided the total allocation to an individual issuer does not exceed 2%.
Issuers that exceed the limit are reduced to 2% and the face value of each of their bonds is adjusted on a pro-rata basis. Similarly, the face values of bonds of all
other issuers that fall below the 2% cap are increased on a pro-rata basis. In the event there are fewer than 50 issues in the Index, each is equally weighted and the
face values of their respective bonds are increased or decreased on a pro-rata basis.
The S&P/LSTA Leveraged Loan Index is a partnership between Standard & Poor’s and the Loan Syndications and Trading Association, tracking returns in the
leveraged loan market and capturing a broad cross-section of the U.S. leveraged loan market - including dollar-denominated, U.S.-syndicated loans to overseas
issuers.
The Bloomberg Barclays US Aggregate Index is a broad base, market capitalization-weighted bond market index representing intermediate term investment
grade bonds traded in the United States
The Bloomberg Barclays Global Aggregate Bond Index provides a broad-based measure of the global investment grade fixed-rate debt markets. It is comprised
of the U.S. Aggregate, PanEuropean Aggregate, and the Asian-Pacific Aggregate Indexes. It also includes a wide range of standard and customized subindices by
liquidity constraint, sector, quality and maturity.
Important Disclosures
This material is solely for informational purposes and should not be viewed as a current or past recommendation or an offer to sell or the solicitation to buy
securities or to adopt any investment strategy. The opinions expressed herein represent the current, good faith views of the author(s) at the time of publication and
are provided for limited purposes, are not definitive investment advice, and should not be relied on as such. The information presented in this material has been
developed internally and/or obtained from sources believed to be reliable; however, Stone Harbor Investment Partners, LLC (“Stone Harbor”) does not guarantee
the accuracy, adequacy or completeness of such information. This material includes statements that constitute “forward-looking statements”. Forward-looking
statements include, among other things, projections, estimates, and information about possible or future results related to market, geopolitical, regulatory or other
developments. Any forward-looking statements speak only as of the date they are made, and Stone Harbor assumes no duty to and does not undertake to update
forward-looking statements. Forward-looking statements are subject to numerous assumptions, risks and uncertainties, and are based on current market trends, all
of which change over time. The views expressed herein are not guarantees of future performance or economic results and involve certain risks, uncertainties and
assumptions that could cause actual outcomes and results to differ materially from the views expressed herein. The views contained in this material are subject
to change continually and without notice of any kind and may no longer be true after the date indicated. All investments involve risk including possible loss of
principal. There may be additional risks associated with international investments involving foreign economic, political, monetary and/or legal factors. These risks
may be heightened in emerging markets. Past performance is not a guarantee of future results. This material is directed exclusively at investment professionals.
Stone Harbor Investment Partners | January 2022 Investment Policy Statement 5CONTACT
Main Office - New York London Office Singapore Office
31 W. 52 Street 48 Dover Street 3 Killiney Road
16th Floor 5th Floor London, Winsland House 1
New York, NY 10019 W1S 4FF Singapore 239519
+ 1 212 548 1200 + 44 20 3205 4100 + 65 6671 9711
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