Two key events triggered a renewed bout of rising bond yields over August: 1) UK headline CPI breaching 10% year-on-year, and 2) US Federal Reserve Chair Powell’s affirmation at Jackson Hole that fighting inflation remains the priority for policy settings, thus pouring cold water on market hopes for a ‘Fed pivot’. UK and European interest rates led the selloff, as they moved to price a much more aggressive profile of policy tightening in order to quell surging inflation. Australian bond yields followed the global moves, but yields rose less. Credit spreads meanwhile ended about unchanged, having narrowed to mid-month, then reversing course.
We added value versus index via our credit hedges, which more than insulated our physical holdings, and the higher interest rate carry position we are now running also added. Our interest rate positioning detracted value, as both our small long duration position and yield curve flattening exposures were negative contributors.
We are managing our duration exposure around a neutral position, with a bias to add more duration as we become more confident inflation is slowing. Our credit positioning remains defensive, but we are patiently waiting for opportunities to become more constructive and extend our credit exposure. Fixed income is offering much better absolute value following the repricing higher in yields, and good value relative to other assets, given the challenging cyclical outlook and central bank policy priorities.
Market Outlook
Key cyclical views:
Central banks are ‘all hands to the pump’ to fight inflation, and have admitted the consequential risk of triggering a recession. Our key views regarding the cycle are:
- There are tentative signs that supply bottlenecks are easing, and commodity prices including oil are well off their highs. These developments should help moderate headline inflation, although the underlying inflation pulse continues to broaden into services, and labour markets remain tight.
- Despite evidence of demand destruction – for example, German manufacturers being forced to reduce operating hours in order to ration energy supply – activity has not yet fallen nearly as sharply as the deterioration in consumer and business sentiment would suggest.
- Nonetheless, a ‘costless’ rollover of inflation back to central bank targets is unlikely. More likely, inflation either stays uncomfortably high, or growth crashes. However, since these risks are now more evenly balanced, we are moving to a bias to extend duration longer than the benchmark.
- Although the tension between elevated inflation and slowing growth is evident everywhere, in the UK and Europe it is even more striking. In the UK, for example, consensus forecasts inflation to hit 14% year-on-year and the economy to tumble into recession by year-end. In contrast, the US and Australia appear to be on more benign paths for both inflation and growth, giving us more confidence to invest in these markets.
The pace of central bank tightening is frenetic, with the Fed raising rates by 2.25% and the RBA by 2.5% within five months. The pace should slow as rates are now moving beyond neutral and into restrictive territory, and the impact of aggregate demand becomes more apparent. However, markets are likely to be volatile as uncertainties over how quickly inflation will fall and the cost of economic growth remain.
Corporate profitability is yet to soften much but is likely to come under pressure as volumes soften and high input costs pressure margins. Markets appear too sanguine about this risk, while we prefer to retain a cautious stance on credit risk.
Strategic assessments:
It seems probable the post-GFC economic and market environments have ended, however not as intended. The RBA and other central banks were caught flat-footed by an inflation surge, and have been forced to abandon stimulatory policy well before strong growth could help reduce the debt burden resulting from COVID stimulus. It remains unclear what the next regime will be, however in our assessment:
- Economies and markets are undergoing a dramatic readjustment. Economies are adjusting to tight labour markets and energy supply disruption, and markets to a significantly tighter central bank policy. Fiscal policy also needs an overhaul – financed by monetary policy keeping rates low, and designed to sustain consumption rather than stimulate investment, it has become too short-sighted.
- Increased uncertainty about medium-term growth and inflation outcomes, impact of climate-related policies, and geopolitical and demographic risks should all result in investors demanding higher risk premia from fixed income and equity assets.
- To a degree this may be priced in. Our three-year expected return forecast for Australian bonds is indicating possible returns of 4% to 6% p.a.
- Bond-equity correlations are subject to a positive shift should inflation stay elevated, causing a rethink on traditional portfolio construction techniques. Some alternative asset ‘safe harbours’ may prove illusory.
Positioning
As described above, the cyclical picture is becoming more supportive of bonds and valuations are much more appealing than at the start of the year. The strategic value of fixed income has also improved with higher yield but overlaid with a potentially more uncertain, higher volatility environment.
- Although we shortened duration in August after the strong bond rally in July, in general we are moving to a more constructive position on rates exposure, as cyclical risks are shifting from upside inflation to downside growth.
- However, with central banks currently tightening very aggressively, and as it’s too early to gauge accurately the impact of their actions on both inflation and growth, we are taking a patient approach to building aggregate duration.
- In general, we continue to expect yield curves to flatten as official rates are increased. However, divergence between yield curves is offering some relative opportunities – the US yield curve, for example, is much flatter relative to other countries.
- Credit faces a very uncomfortable macroeconomic mix, with downside growth and profitability risk adding to liquidity headwinds from deleveraging. However, spreads have moved significantly wider already, and while we believe riskier, high yield credit is still vulnerable, higher quality investment grade corporates offer good carry especially on an all-in-yield basis.
- We are being even more patient in adding to credit exposure than to duration. We will become more constructive as recession risks are increasingly priced.
In no sense are we relaxing, as the next six months or more could prove as challenging as the last. However, we are now optimistic that better fixed income returns are ahead and that fixed income will retain strong strategic value to portfolios. Our portfolios are well placed to deliver both, and we are carefully becoming more constructive in our portfolio settings.
