April drew to a close with recession still an expectation, not the reality. Economic data generally continues to moderate, but is not yet dire, while inflation, the key focus of policy maker attention, is also starting to soften but remains uncomfortably and stubbornly high. While bond markets are reflecting the ongoing tussle between these factors, equities in April (at a headline level at least) seemed to reflect a more positive interpretation of events.
We remain of the view that recession is the most likely outcome for key economies, given the accumulated policy tightening and the eventual outworking of Covid stimulus, and remain very defensively positioned. Unfortunately, the confluence of current economic outcomes is uncomfortable for central banks and rates are more likely to rise than fall in the near term. Any potential for rates cuts seems remote and in our opinion is not a 2023 scenario.
Lights flashing red for recession
Our conviction in looming recession (both in Australia and in key global economies), is reflected in our recession indicator which has been flashing red for 12 months now, with 65% of the indicators signalling recession. US employment, a lagging indicator, is starting to show some cracks. Although the headline unemployment rate remains at historical lows at 3.5%, initial jobless claims are now starting to rise. This means that they are finally correlating with other negative labour market signals and we expect the unemployment rate to increase over the remainder of the year. We are also cognisant that monetary policy acts with a lag and while rates have been rising steadily for 12 months now, starting rates were low and the pass-through to household and business cash-flows more muted.
If proof that higher rates are having a negative impact is required, then we need to look no further than the unfolding crisis in US small/regional banks, where the Federal Reserve’s policy actions have exposed the accumulated risks of the free money era on bank balance sheets, as well as a flawed regulatory framework and poor management in some of these banks themselves. The pressures here will likely lead to a further tightening in lending standards by US banks, which will restrict access to credit to the riskiest borrowers, both household and corporate. Bank lending standards have already increased and are consistent with levels prior to past recessions. The chart below shows a Federal Reserve survey of the percentage of senior loan officers tightening lending standards and the US high yield default rate. The latest survey was conducted prior to Silicon Valley Bank being closed by US regulators, but shows a significant tightening in lending standards was well underway and consistent with a significant increase in the default rates of the most risky corporate borrowers. The next senior loan officers survey is due out in early May and we expect confirmation of a further tightening of lending standards.
The Reserve Bank of Australia is well aware of the long and variable lags of the impact of previous monetary policy decisions and while political pressure on the RBA has been intense, a pause in April after a cumulative 3.5% lift in official rates since May last year was justifiable. However, slowing down the pace of tightening is sensible. Inflation, while moderating, remains way too high for policy maker comfort. This unease was reflected in the RBA’s decision to lift rates in early May to 3.85%, despite market expectation for an extended pause. The Fed also raised rates again in early May, with a clear message that while there are positives in the global inflation fight, the fight isn’t over and inflation remains uncomfortably high.
Portfolio positioning shifts
Over the past few months, our strategy has been shifting to increasing duration risk and reducing credit risk as the balance of probabilities shifts towards a recession in the US and Australia. We have been reducing exposure to credit, particularly higher risk credit, as we believe the riskiest borrowers will struggle to refinance their debt as lending standards tighten. This is an intentional consequence of tighter monetary policy. Credit availability (at any price) will be restricted for both households and corporates that have high debt loads and reduced capacity to pay. The credit binge honeymoon is over! Current credit spreads for non-investment grade issuers are insufficient to compensate investors for the level of defaults that typically occur in a recession, so we have cut all exposure to high yield credit and have implemented hedges via credit derivatives in high yield to reduce overall portfolio credit risk.
We have been increasing duration exposure whenever yields backup. Duration has increased to 2.5 years, from 1.75 years at the end of last year and we expect to increase further as opportunities present. We have favoured longer dated maturities to gain duration exposure in both the US and Australia, as shorter maturities are still exposed to further policy tightening. Again patience is required, but we expect yields to eventually decline as central banks succeed in further moderating inflation and growth starts to contract.
Our foreign currency exposures remains skewed to defensive currencies, mainly the USD and the Japanese yen (JPY). Historically the yen has performed well during cyclical declines, particularly against the Australian dollar, and together with our US dollar (USD) exposure, provides a downside risk hedge (alongside our duration exposure) against further weakness in credit spreads. In addition, the yen remains very cheap historically and we patiently wait for the new Governor of the Bank of Japan to begin the process of dismantling their yield curve control policy, which should lift bond yields and the yen.
Our equity position is key in terms of downside portfolio protection. At 15%, it is close to historic lows and skewed to Australia, Japan and emerging markets, which we see as being both the lowest risk and best value. Our US exposure is close to 0%. Interestingly, returns form US stocks this year have been driven almost exclusively by a handful of large tech stocks on the back of optimistic rate expectations, which we don’t think will be sustained.
The flip side of this is that our cash weight remains high, with around 1/3 of the portfolio currently in cash (which now pays us a decent nominal return as well as being a good short-term store of value). It’s important to note here, though, that we have increased activity in the portfolio over the last 18 months, as both economic and market volatility have increased. We see this as being more consistent with the broader environment where liquidity is less abundant and assets need to compete for capital. This means fundamentals matter again, as opposed to abundant liquidity driving prices, and we expect this heightened level of portfolio activity to continue and to be reflected in both asset allocation and implementation decisions.
