Fixed Income: Defensive but flexible
Stuart Dear, Fund Manager, Fixed Income explains that in a challenging return environment, we believe being positioned defensively but with flexibility to engage emerging opportunities remains the appropriate strategy.
Markets endured a dramatic round-trip over the quarter, revealing the inherent volatility of an unstable relationship between markets and central banks. The January and February weakness in equities and credit was partly caused by fears that central banks were either creating instability (for example as bank profits are crimped by negative rates) or they had simply ‘run out of bullets’. The dovish responses in March from both the ECB (further easing) and the Fed (cautious communication and a more subdued outlook) were acknowledgement by each that there is a feedback loop between markets and policy.
What this reaction function implies is that market volatility is important for economic outcomes, and therefore something which central banks should be concerned about. While there are clearly wealth and confidence effects of markets on the real economy, this logic holds most powerfully if market volatility is capturing a rapidly rising probability of extreme economic tail risks, however the last quarter was not about this. Mostly, markets seemed worried that central banks couldn’t do enough to move economic outcomes from their recent benign trajectory – ie low but relatively stable growth in both real and nominal terms (witness US payrolls growth chugging along at a virtually robotic 200k per month). Why this is important for markets, of course, is because a range of assets rely on growth to support their valuations.
The global economy faces challenges from the slowdown in China, some reversal in the pace of globalisation (as currency wars are fought, protectionism rises and trade slows) and in most places an unwillingness (and often inability given high debt levels) of governments to make use of the time bought them by the accommodative policy of central banks. With the old credit growth model clearly not working as well as it used to, other (non interest-rate based) policy methods may well be required. This leaves central banks potentially reaching for the unattainable, and markets looking for unrealistic returns based off these lofty goals (*or a continuation of policy liquidity/backstop support), and hence the continuation of the low growth/volatile market environment.
Avoiding over-extrapolation of the short term, recognising genuine shifts in fundamentals, and an underlying focus on valuation, are hallmarks of our style. Our analysis of recent developments suggests that the risks of (US) recession have increased slightly (as the cycle grows older), that deflation remains an ongoing structural threat (through technology, globalisation and demographics), but that cyclical inflation risks have moved a little higher. Meanwhile, valuations have shifted – government bonds have become more expensive, and credit assets cheapened back into attractive territory by mid-February before rallying sharply.
We’ve been vocal about our views on fixed income indices as inappropriate yardsticks of risk for some time. While the long duration sovereign risk of the Australian benchmark, for example, may (assuming still positive yields on bonds and continued negative correlation between bonds and equities) continue to provide a reasonable hedge to equity risk, this diversification benefit may be outweighed by the potential for capital loss. As such, our portfolios, designed to be defensive in both an equity-relative and absolute sense, look quite different to valuation-agnostic benchmarks.
In particular, we’re continuing to run duration materially shorter (at -1.1years) than the ever-lengthening (and hence riskier) benchmark, though we have about, historically, an average level of absolute duration in the portfolio now. Through the quarter we slightly lengthened duration as yields rose in March. Compositionally our short is split between the US (most cyclically advanced), Germany (worst valuation) and Australia, while we are also positioned for curves to steepen on possible pricing of higher inflation risk premia (or stronger growth). While the timing of the payoff of this duration stance is unknown, the March quarter has shown (again) that valuations can move rapidly – albeit in this instance the weakness came in credit.
Our main positioning change through the quarter was our increased allocation back to investment grade credit given the improved value on offer in early February. However, the subsequent tightening of credit spreads saw us remove this exposure by late March, and in early April we are looking to trim our global and domestic credit allocations further. With valuations back closer to fair and 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 cheapened significantly during the quarter - back to our targeted entry levels - though we only allocated small amounts to our defensively-oriented fixed income portfolios given the risky nature of those securities. Domestic RMBS also repriced wider and we topped up our exposures back to target levels. 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. Meanwhile cash remains a preferred allocation.
With a significant underweight to duration risk, only moderate credit exposure and high effective cash weight the Portfolio is well positioned to continue to provide defensive absolute outcomes, albeit that the market-policy dependence may impair short term relative returns. In a challenging return environment, we believe being positioned defensively but with flexibility to engage emerging opportunities remains the appropriate strategy.
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