Fixed Income

Sticking to our style

Stuart Dear, Fund Manager, Fixed Income, explains that we are well positioned to continue to provide defensive absolute outcomes, albeit that the cyclical and policy making uncertainty may impair short term relative returns.


Stuart Dear

Stuart Dear

Deputy Head of Fixed Income

Premiums for risky assets were pummelled wider in the first half of February, further darkening markets’ rough start to 2016, as a sense of gloom enveloped markets that either (or both) 1) central bank policy was becoming a destabilising influence (for example as bank profits are crimped by negative rates) or 2) monetary policy’s effectiveness to stimulate economies is nearly exhausted (the price doesn’t matter if debt overload means an unwillingness to borrow more). Government bonds - now a key policy instrument, and hence potentially subject to premium adjustment of their own if, as a result of failings, policy emphasis were to shift away from monetary policy towards other forms of stimulus (fiscal policy, or cash printing) or longer term structural reform – richened further in typical response to adverse moves in the growth asset classes, and indeed on expectation that this would trigger further central bank easing.

While the expectation of further similar policy action in the face of perceived policy failure is somewhat paradoxical (‘monetary policy is dead, long live policy!’), also worth noting is that the economic reality is considerably different to markets’ perception. Large parts of the developed world economy are operating at close to full capacity – witness the unemployment rates of the US, UK, Japan and Germany, each near cyclical lows – and have been in a reasonably steady state of moderate expansion for the last several years. Inflation has remained benign and actually reasonably stable in spite of big commodity price moves (in both directions since the GFC). Central bank policy can surely take some credit for the relative stability in macroeconomic outcomes in developed economies (having acted as a volatility dampener). Wild swings in markets are simply not reflecting this economic reality.

Equally, however, to say that all is well in the world is also untrue. Emerging economies have notably decelerated, for both cyclical (USD and commodity price pain) and structural reasons (lack of growth in developed economies pressures the export-led growth model, build-up of debt, reliance on foreign capital etc.). The economic model for developed economies has changed post-GFC – with high debt levels, the credit multiplier is unlikely to be the driver for growth that it once was; suggesting policy frameworks (and methods of calculating the economic data to which frameworks are calibrated) need adjusting. Divergence among the major central banks is also undermining the support for assets which were valued beyond their fundamentals, which, through greater sensitivity to wealth and confidence effects, is likely to constrain real economic activity.

Avoiding over-extrapolation of the short term, recognition of genuine shifts in fundamentals, and an underlying focus on valuation, are hallmarks of our style. Our analysis of recent developments suggests that risks of (US) recession have increased (as financial conditions have tightened and corporate profitability is slipping), and deflation remains an ongoing structural threat (through technology, globalisation and demographics), but those fears, with respect to each one, have been overblown in the short-run. Meanwhile, valuations have shifted – government bonds have become more expensive, and credit assets have cheapened back into attractive territory.

Our focus on valuations, being the key driver of longer-term return and risk outcomes, leaves us continuing to run a duration position materially shorter (-1.30yrs) than the valuation-agnostic benchmark, with the short being roughly evenly distributed between Australia, Germany and the US. It’s important to note that most of our relative short duration position is due to the benchmark lengthening materially since the GFC – over the last few years we have actually added duration to the portfolio and have about an historically average level of absolute duration in the portfolio now. Some deterioration in the cyclical outlook has tempered our inclination to sell more duration at current yield levels.

Our main positioning change has been our increased allocation back to investment grade credit given the improved value now on offer. However, with some deterioration in corporate fundamentals and in market liquidity conditions we remain cautious in both our overall allocation, and in our selection, preferring high quality shorter tenor bonds. Bank capital paper has cheapened back to our targeted entry levels, though we are only allocating small amounts to our defensively-oriented fixed income portfolios given the risky nature of those securities. We 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 bonds and challenged liquidity, preferring cash, top-rated domestic RMBS and corporate exposures.

With a significant underweight to duration risk, only moderate credit exposure and high effective cash weight, we are well positioned to continue to provide defensive absolute outcomes, albeit that the cyclical and policy making uncertainty may impair short term relative returns. In a challenging return environment, we believe being positioned defensively with the flexibility to engage emerging opportunities, is the appropriate strategy.

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