Amid shifting markets, Fed in search of the elusive 'neutral' level

2018 has been a challenging year for global financial markets, as investors have had to deal with greater economic uncertainty, less dovish central banks and more volatile asset prices. As the last month of a volatile year begins, policy surprises and policy hopes are delivering only partial stability to global markets. The surprise has been Fed Chair Powell’s dovish speech at the end of November, while the hope focuses on the tariff relief from the Trump-Xi meeting held at the G20 summit. The macro environment has certainly become a lot more complicated with signs of tighter financial conditions, withdrawal of global liquidity, lower oil prices and potentially a lower need for restrictive US interest rate policy.

Recently, the markets appear to be sharply repricing the growth outlook and a much more dovish Fed outlook. The US economy appears to be coming off its ‘sugar high’ where it has been carrying a lot of momentum this year with relatively loose monetary policy. The plunge in energy prices will support economic growth over the coming months, but higher borrowing costs are increasingly weighing on interest rate-sensitive spending which, together with the fading fiscal stimulus, will cause growth to slow next year. The large fall in oil prices will significantly reduce pressure on headline inflation and, indirectly, the broader inflation pulse in the US. But rising wage growth and lower oil prices should prevent growth from slipping below ‘trend’ as consumer spending remains well supported. Given this, we believe the Fed looks set to continue raising interest rates – though perhaps at a slower pace – in search of the elusive ‘neutral’ level.

Another risk to the market outlook is the tricky hand-off from quantitative easing (QE) to quantitative tightening (QT) that is underway. This withdrawal of global liquidity is central to the cracks that have appeared across risky assets the last few months. Credit markets will be happy to say goodbye to the month of November. Spreads widened significantly across all regions as equity markets’ weakness plus an increasing market focus on credit fundamentals took their toll. Most credit markets have continued to struggle as evidenced by new 2018 spread wides on US and Euro investment grade and high yield corporate bonds. Global QE provided the necessary conditions for corporations to lever up, which is exactly how they responded. Outstanding US corporate credit market debt has more than doubled with the biggest component of it coming in the BBB portion of the credit curve, the lowest of investment grade ratings. We remain concerned that leverage is at historical highs, largely due to low interest rates, leaving corporates vulnerable to shocks (both interest rate rises and earnings shocks).

The volatility in markets has given us an opportunity to reposition the portfolio by adding back to duration in both the US and Australia. We have progressively trimmed our short duration position in the US as yields rose in the first half of November and we became more concerned on the growth and inflation outlook shifting lower. We would expect to add more duration to the portfolio as the US cycle continues to mature, monetary policy moves more restrictive and risky assets become more vulnerable. In Australia, we added duration as the market underperformed other global bond markets in November and the cycle remain neutral with the RBA firmly on hold.

The portfolio is now 0.35 years short duration vs benchmark. We are short 0.25 years in both the US and Europe in the front end of curves where we believe there is more room for policy adjustments. We have moved longer duration in Australia vs benchmark where we are seeing slower than expected economic growth, a protracted housing correction and weak wage growth. We continue to hold exposure to inflation-linked bonds in both the US and Australia where inflation risks are underpriced in markets vs central bank targets.

In terms of credit risk, the portfolio remains defensively positioned, holding a modest amount of credit exposure to increase the carry component of the portfolio. Credit market valuations have generally improved over the last few months as investors appear to have started to embrace the idea that end-of-cycle risks are rising. Sentiment in credit markets is much less uniformly bullish than it was at the beginning of 2018. We are progressing through the “late cycle” phase of the credit cycle but a deterioration in corporate fundamentals does not appear imminent. Leverage is at historic highs, largely due to low interest rates, and corporate profits are growing but at a decreasing rate. Risk appears to be concentrated in the loans market, lower rated high yield segments and the BBB’s in investment grade (covenant lite). We continue to avoid riskier US credit where valuations are, in our view, still stretched, and prefer owning higher quality, short tenor Australian credit. In aggregate, our absolute and relative to benchmark credit exposure is low.

Altogether, our cautious positioning leaves the portfolio well-placed to deal with a more challenging market environment ahead, and ultimately to respond to developing opportunities to position for more constructive future returns.