Kellie Wood
Bond markets have performed well recently as concerns over near term growth have increased. But we believe we are entering a consolidation phase, waiting for central banks to signal the gradual unwinding of the emergency policy settings, amid the uncertainty of the future path of inflation.
A resurgence in concern over weakening global growth dominated market moves in July. Global government bonds benefitted from their safe-haven status and yields fell sharply, generating positive absolute returns. Recent yield behaviour does look similar to previous mid-cycle slowdowns where markets have been focused on the sharpness of the US growth deceleration on the back of a declining reopening impulse and negative fiscal impulse. New Covid-19 outbreaks are weighing on growth which puts at risk further recovery in the lagging parts of the services sector and slower growth overall. While we think there will be a slowdown, the recovery remains on track with high vaccine efficacy against severe infections resulting in fewer restrictions going forward and a reduced drag on economic activity. Market pessimism around the durability of the recovery and peaking growth rates for this cycle looks overdone, though could take some time to reverse.
US output and labour market gaps are still closing even with slowing growth, and markets normally price in substantial rate increases into the yield curve when the US Federal Reserve is closing in on its mandate of full employment – this argues for a higher level of intermediate and longer maturity yields. Although we still believe this to be the case, our recent reassessment of the economic outlook suggest these gaps may take longer to close and therefore the upward repricing of yields may not be quite as front loaded in 2021, presenting downside risks to yields in the short term. The upcoming labour market reports should offer some insight into the time frame – large above-trend job gains could allow for a faster return to higher yield levels, whereas more modest gains could leave bond yields in limbo.
In Australia, the Reserve Bank of Australia (RBA) showed a steady hand at its recent meeting, maintaining the new guidance and policy commitments laid down in July. A month ago, the board announced a step back in bond purchases and that the yield curve target would ease. Prolonged lockdowns are likely to weigh on growth more heavily than previously expected in spite of recently announced fiscal support for businesses and households. The RBA is likely to incorporate this by lowering near-term growth projections and continuing to support the economy with very accommodative policy. On policy rate guidance, virus headwinds and recent data confirming underlying price pressures remain subdued and considerable labour market slack is likely to keep the bank steadfast in its guidance that rate hikes are unlikely until 2024 at the earliest. In recent weeks, the extent of interest rate increases priced into the market have started to unwind, and we see risks for a further extension of these moves.
We are firmly in a mid-cycle environment which is normally good for credit assets and conventional wisdom is that financial markets are awash with excess liquidity. On the surface, this argument makes a lot of intuitive sense: zero rates, continued quantitative easing and ample fiscal stimulus are all supportive of risky assets. Besides, households are flush with cash, businesses are expanding profits and investor optimism is high. What could go wrong?
In our view, these forces explain why both equities and credit markets have performed very well and compressed risk premiums, but with risky assets now at very expensive valuations most of these stimulative forces are either spent or priced in by markets. Central bank support is being progressively withdrawn and corporate earnings remain at risk of a sudden and unexpected earnings shock or disappointment. Key leverage metrics are improving with the strong earnings; however, the longer term build up in leverage leaves key credit markets vulnerable to earnings shocks together with the very real likelihood of higher interest rates. Going forward, all this suggests we could see increasing risk of periodic setbacks for risky assets.
Portfolio positioning
After a volatile start to the year, markets have now reassessed the growth outlook as we move through the second half of 2021. We have moved past the point of peak expectations in growth and inflation with further moderation expected in the near term. This delays any action by central banks to tighten policy as further progress is needed to fulfill their goals. This outlook keeps us neutral portfolio duration against the benchmark. We remain long in those markets where we see value, particularly in Australia. Canada and Korea are also attractive markets where several official interest rate increases are already priced in. In the US, where there is the most upside cyclical pressure, we are maintaining a short position and a relative inflation position. Over the last month we have continued to take profits on our strategic yield curve flattening positions in Australia and the US as well as holding Australian inflation-linked exposure.
With this cycle being much more advanced and dynamic than recent cycles, market pricing in credit has moved well ahead of corporate fundamentals, leaving some asset classes at very expensive valuations. In the near term, asset classes like US high yield are vulnerable to a correction and our most recent adjustments to the portfolio was to add some further protection against spread widening. Our preference remains for higher quality carry, short duration credit assets like Australian investment grade, although we recently added some protection given the broader asymmetric risk in credit markets.
The longer-term outlook for credit will be shaped by a tug-of-war between low interest rates fostering easy financing conditions versus contributing to a build-up of excessive risks. The recent volatility in Chinese credit markets is a good example of heightened liquidity and refinancing risks in high yield issuers as the government takes action to increase regulation. Even though we are expecting near-term volatility to stay elevated, valuations in this asset class are looking very attractive compared to developed credit markets.
We are maintaining our modest exposure to Asian credit to help diversify, alongside US securitised debt and emerging markets. Overall, we are well positioned for this consolidation phase in bond markets where our key positions include owning higher quality investment grade credit alongside some protection in lower-rated credit, positioning in longer-dated government bonds in those markets where we see value but also looking to capture relative value opportunities between countries. We also remain focused on taking advantage of the shorter term moves in markets as this served us very well in 2020 and early in 2021.
By Kellie Wood, Fund Manager, Fixed Income
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