Fixed Income

Defensive outcomes developing opportunities

Stuart Dear, Fund Manager, Fixed Income, explores defensive outcomes developing opportunities.


Stuart Dear

Stuart Dear

Deputy Head of Fixed Income

It was a rough year for markets as policy divergence in the West and slowdown in China drove USD strength, commodity price weakness and emerging economy instability. Sovereign bond yields ended little changed, but (especially longer tenor and riskier) credit weakened on default concerns in the energy sector and heavy supply, while EM debt suffered capital flight. Apparent stability in standard volatility measures (such as VIX and MOVE) belied the increased choppiness in markets compared to the prior several years during which global policy broadly moved in the same direction. In 2015, there was uncertainty around if/when the Fed would begin to raise rates. Distortions generated by ECB policy implementation, several currency policy u-turns (e.g. Switzerland, China), concern over reserve de-accumulation, and diminished liquidity as a result of increased regulation were all sources of unease in markets. This had previously ridden policy accommodation to expensive valuations in virtually every asset class.

Fundamentally, the continued weakness in oil and other commodity prices was undoubtedly the major story. In addition to supply side aspects (the big ramp up in capacity at higher costs of production, and the geopolitics of OPEC’s production decisions), softer commodities reflected weakening demand across emerging economies, compounded by ongoing sluggishness in developed market industrial production and capital expenditure. With consumption reasonably well supported by employment gains in the service sector, however, developed economy activity held about steady at near trend growth rates. Inflation, meanwhile, moved lower on headline metrics in developed economies, and remained subdued on core measures, while within emerging economies it varied greatly depending on currency moves.

Starting from expensive valuations, our valuation driven approach has seen us run considerably less duration than the ‘expensive’ benchmark through the year, though with yields roughly going sideways this has been a frustrating experience. Our approach has meant we’ve been earning less income than the benchmark but with considerably less capital variability and greater liquidity. A more tactical trading approach may have been able to capture some value, though this is questionable given the choppiness of the environment. In credit our approach has been cautious in an absolute sense, but an overweighting versus the government-heavy benchmark has cost us. In absolute terms we’d argue that better fixed income portfolios are more diversified than the benchmark.

We enter 2016 facing similar challenges. While markets have rebalanced this year, most of it has been between countries – via shifts in exchange rates, incomes (courtesy of commodity moves) and stores of wealth (reserves). In aggregate, the mediocre-growth, low (real economy) inflation environment hasn’t changed materially through the course of the year however our central expectation is that economies ultimately step back towards normal conditions and rates of return on investments are more closely linked to those economic outcomes. Sovereign bonds remain expensive versus even conservative estimates of normalcy, implying both low future returns and a high probability of loss, and notwithstanding that some value that has been created in riskier assets through market moves over the year, the overall prospects for fixed income markets remain challenging.

In an uncertain world where the risks are always numerous, one of the key things we are watching is US inflation. Our analysis of US inflation suggests a broadly benign, but rising trend in core US inflation in 2016 on the back of labour market tightness and a pass through of the oil price shock and USD strength. However, a pick-up in the pace of inflation would cause a reassessment of the market’s current ‘patient Fed’ view and potentially be the catalyst for the asset repricing - of both bonds and riskier assets - that our medium term return estimates anticipate. Policymakers in the West and East face an enormous challenge to engineer smooth economic transitions in challenging cyclical conditions and in light of persistent structural imbalances.

We continue to run a duration position materially shorter (-1.40yrs) than the valuation-agnostic benchmark. While valuations are expensive everywhere, we’ve run most of the short in the US owing to the relative outperformance of the US economy and proximity of Fed tightening, and held smaller shorts in Australia and Germany on valuation grounds. We’ve been broadly correct in our relative country positioning as Treasuries have underperformed, and have begun to rebalance our short exposure more evenly geographically. However, the aggregate duration position is unlikely to change meaningfully until we see yields materially higher, or the cyclical outlook takes a significant turn for the worse.

We see valuations in credit being about fair, with recession (which drives defaults) unlikely, though we remain cautious generally, especially given some deterioration in corporate fundamentals and in market liquidity conditions. Our preference remains for high quality shorter tenor bonds, though subordinated local bank paper and even some non-financial hybrids are beginning to look attractive. We also continue to run a collective underweight position to the non-credit spread sectors (i.e. semis and supras) given the modest additional return they offer versus government, preferring cash, top-rated domestic RMBS and corporate exposures.

Preserving capital as markets adjust is a priority; 2015 has made it clear that patience is required. Effective cash remains above 25% and the Strategy is well positioned to continue to provide defensive absolute outcomes as well as being able to take advantage of the developing opportunities.

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