Markets continue to oscillate as economic data neither confirms nor denies the bull or bear case for risk assets. Two key US economic prints diverged in the first quarter, with US GDP coming in stronger than expected, highlighting how robust the economy remains, but Gross National Income (GNI) contracted for a second quarter and remains recessionary. There remains a divergence between leading indicators, such as Purchasing Managers indices flashing recession and hard economic data remaining more buoyant. These kinds of conflicting signals are typical towards the end of a cycle, as an economy starts to sputter out, but it’s not clear how fast or how far growth will decline. We still believe we are heading for a recession, with our US recession model continuing to flash red with over 65% of the indicators signalling recession (the highest level since 1990).
Thinking through the possibilities
As we look forward, it’s worth considering a few different scenarios and the potential portfolio positioning of credit and duration in each. The first scenario is a soft landing. This is where economic growth slows but a recession is avoided; the ‘Goldilocks’ scenario. Inflation has declined and under control without causing significant damage to the economy and business conditions remain favorable. In this situation, credit assets as well as duration are expected to be supported as growth remains positive and inflation is falling. As such, holding assets with sensitivity to duration and credit spread is the favoured approach. Furthermore, subject to valuations, high yield credit would also be well supported and expected to provide superior returns to investment grade credit. We note that the Reserve Bank of Australia has commented that this is a “narrow path” to achieve.
The second scenario is a typical business cycle recession caused by a central bank tightening cycle. This entails a sharper fall in economic activity as central banks are forced into more rate hikes to reduce inflation and in the process something breaks. We would expect to see rising unemployment, falling asset prices and a rise in personal and corporate bankruptcy. This scenario would warrant holding significantly more duration exposure and much less credit. Of the credit holdings, exposure to high-quality investment grade credit is preferred and avoiding high-yield credit. With corporate defaults expected to rise, the avoidance of weaker credits through active stock selection is extremely important.
The third scenario to consider is that of a high inflation scenario. In this situation growth initially weakens, but after a pause in the tightening cycle inflation remains too high, resulting in further interest rate increases by central banks. Both inflation and interest rates stay higher for longer, but higher rates eventually triggers a much deeper recession. In this scenario, higher cash holdings are preferred initially to reduce both interest rate risk and credit risk. Credit exposure needs to be higher quality and preferably floating rate. Once inflation looks to have peaked, a switch to higher duration exposure would then be warranted.
While there may be other potential scenarios as we look forward, our base case remains that of a typical business cycle recession. Given this, we have been reshaping the portfolio’s credit, duration and currency exposures. We have a higher emphasis on duration and have reduced credit but retain a focus on higher quality credit exposures. Importantly, we have a short global high yield exposure via credit derivatives, which is the segment of credit markets that is the most vulnerable to recession and a widening of credit risk premia. We have also increased foreign currency exposure. Chart 1 below provides the portfolio’s exposures to credit, duration and currency over the past 2 years, measured in equivalent risk units and taking into account their correlations. This shows the significant shift away from credit risk towards duration risk that we have implemented.
To summarise, as interest rates have increased, we have increased duration exposure to 1.8 years. As our concern over the global growth cycle has also increased we have increased currency exposure to 6.5% by adding a long Euro position. We have retained the long USD and JPY positions which are expected to perform well if risk assets come under pressure. Within a lower credit allocation we have increased the credit quality of the portfolio and focused on where we see the most value, in Australian investment grade credit. Cash remains high at 27% and the portfolio yield to maturity is near 5.0%.
Overall the portfolio remains defensively positioned as we expect to see the negative impact of slowing growth on equity prices and increasing risk of a default cycle causing credit assets to underperform sovereign bonds over the coming months. We continue to monitor the incoming economic data and remain highly liquid, ready to re-position the portfolio if our view changes, particularly if central banks are successful in engineering the fabled ‘soft landing’.
