Commentary: Central banks continue to maintain the inflation rage
While central banks continue to signal their intent to fight inflation with words and deeds, equity and credit markets continue to suffer a painful adjustment.
Financial system stress
The painful adjustment to more appropriate monetary policy settings continued in September as bond and equity markets continued to sell off. The S&P 500 fell 9.3%, taking the decline this year to -23.9%. US government bonds continued to weaken delivering a return on US 10-year treasuries of -4.7% and -15.7% year-to-date. The bond bear market has now wiped out 10 years of cumulative returns on US 10-year government bonds – the worst performance since the 1950’s. Against this, the USD remains strong, rising +3.1% in September in trade-weighted terms (or 16.8% year-to-date).
Given the extent of official rate hikes and the large falls across equity and bond markets, it is not surprising to see significant stress running through the financial system. Market rumours are swirling around the solvency of several investment banks including Credit Suisse and Deutsche Bank. The immediate pain point, however, has been in the UK where the British pound (GBP) depreciated heavily, and UK bond markets sold off with the UK budget committing to significant unfunded tax cuts at the same time the Bank of England (BoE) is tightening policy to battle rampant inflation. Large and quick market moves placed the UK pension fund system under enormous pressure as funds were forced to liquidate assets to meet collateral calls on their derivative positions. The BoE intervened to avert risks to the UK financial system and a spill-over into the global economy.
At this stage we don’t believe that the BoE intervention has changed the fact that central banks will continue to hike official interest rates to deal with the inflation challenges. The risk of inflation becoming embedded is real and central banks need to remain on task. That said, we may see some adjustments to the pace of tightening from central banks as they navigate a difficult course and system pressure intensifies. The RBA is one such example, where they recently adjusted the pace of interest rate hikes by hiking 25bp rather than 50bp. This surprised the market with 21 of 28 economists expecting a 50bp increase. The RBA noted that ‘the cash rate has been increased substantially in a short period of time’, restated that it ‘remains resolute’ in returning inflation to target, and flagged that it ‘expects to increase interest rates further over the period ahead’. The RBA appears concerned about overtightening, given global uncertainty, however with inflation yet to peak in Australia, growth remaining intact and the labour market remaining tight, they have a narrow path to navigate.
The reality remains, however, that central banks are tightening into a slowing global economy and the risks around recession are rising. Furthermore, liquidity is being withdrawn as central banks shrink their balance sheets through quantitative tightening.
Liquidity remains important
Against this backdrop, we continue to see liquidity as an important element in constructing portfolios. Cash has many benefits but is often underestimated in its importance. ‘Cash is trash’ is a common refrain when risk assets are running, but across a cycle cash plays an important role in portfolio construction. Cash is capital stable, highly liquid and has option value that allows opportunistic repositioning of portfolios, particularly when markets become dislocated.
This is particularly relevant as market adjustments have seen valuations improve and importantly outright yields have risen significantly, driven by both higher bond yields and higher credit risk premium. The benefit of this rebuild in yields is an improved outlook for forward-looking expected returns, even though we expect continued heightened volatility as uncertainty remains high.
The breakeven point at which bond holdings can withstand higher volatility and still deliver positive returns going forward has improved. For example, global high yield bonds are currently offering an outright yield of 10% compared with less than 5% 12 months ago. If spreads do continue to widen it remains possible to still generate positive returns. Global high yield bonds still have challenges in a rising rate environment and the credit risk premium can easily move much wider, however at current levels, they are starting to look interesting. We understand it is near impossible to pick the top or bottom of a market. As such, as valuations and yields improve our process leads us to begin adding risk and averaging in.
In terms of portfolio positioning, we continue to be defensively positioned with high levels of liquidity through elevated cash levels. The yield to maturity of the portfolio at the time of writing was 4.25%. As we look forward, we expect this to continue to rise as we continue to deploy cash at higher yields. We are beginning to lean into markets to deploy cash into high-quality issues, as we aim to improve the portfolio yield whilst maintaining a focus on managing downside risk.
In terms of duration, we are beginning to add to our current positions. We have held very low levels of duration and hence we have managed to avoid much of the pain in the bond sell-off. We are seeing duration in the neutral range and have moved from 0.4 years to closer to 0.75 years. We expect this will add additional yield to the portfolio and also be of benefit if we do see central banks slow the pace of tightening.
Currency continues to be a downside risk hedge, given duration has been ineffectual, however we are holding minimal exposures. We retain a long USD position, which we believe will be a reasonable risk hedge in an economic downturn. We will continue to assess market conditions and be ready to act accordingly.
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