After a tumultuous 2022 we move into 2023 with the possibility that inflation starts rolling over, which allows central banks to respond by slowing the pace of monetary tightening. On the growth outlook our base case remains a recession in the middle of next year with our US recessionary dashboard flashing ‘red’ with 60% of components signaling a recession. This brings the possibility that the peak in rates for his cycle has been priced into markets. At the time of writing the market is pricing in a peak in the official cash rate of 5% in the US and 3.85% in Australia, which is only one or two more rate hikes from today’s policy rates of 4.50% and 3.10% respectively.
If inflation has peaked and central banks shift into a ’policy pause’ and we enter a shallow recession, this should prove positive for both rates and high quality credit. That said, in previous cycles where inflation has been above 8%, it has tended to stay elevated for longer and doesn’t return to as low a level prior to when it started to rise. As we move through the next phase central banks will be very focused on the shorter term data as they adjust monetary policy settings. Markets are likely to remain volatile as they look to anticipate the reaction function of central banks and the path of future rate adjustments.
Shifting to a constructive position
Although uncertainty remains, valuations have improved in credit and duration based assets and as such portfolio positioning has become more constructive. In terms of credit markets we continue to favour investment grade over high yield. Investment grade credit across most markets is pricing in a recession and as such we believe we are being compensated for the risks we see as our base case. Even if we do see weakness in the corporate earnings outlook and the associated spread volatility, the extra yield over government debt remains attractive. We have thus added to our positions in investment grade credit in both Australia and the US. More recently we have added investment grade exposures in Europe but focused on shorter maturity debt. This provides the portfolio with higher yield, partially due to hedging the currency exposure back to Australian dollars, but given it is short-dated it should be less sensitive to the potential earnings risks and spread widening.
We remain concerned about high yield credit which we still see as unappealing from a valuation perspective. While overall yields have improved with both higher bond yields and wider credit spreads, we still see the risk premium on offer as insufficient. High yield is not pricing in a recession and as such the risk remains that spreads can move considerably wider from current levels.
Managing interest rate risk and currency exposures
We have been adding back to duration and increasing our exposure, given improved valuations and more attractive expected returns looking forward. However, the rally in bond yields in the first half of December lead us to tactically reduce some of the interest rate risk in the portfolio as we actively manage our overall interest rate sensitivity. On the currency side we still hold a small long USD position. As bond yields have risen and valuations improved, the effectiveness of duration as a hedge has improved. As such we are holding more duration, which also provides yield to the portfolio and assists in managing downside risk on credit exposures and expect less emphasis on foreign currency going forward.
As at year end cash exposure is at 30% of the portfolio, down from a peak during the year of close to 50%, reflecting the reinvestment we have made into credit and duration assets to take advantage of higher yields and credit spreads. As we expect uncertainty around the trajectory of inflation and growth, resulting in higher volatility, we will be managing the cash level actively to ensure we are in a position to take advantage of opportunities as they arise.
