Commentary: Continuing the search for high quality yield
We continue to deploy cash into high quality credit assets as we look for a peak in inflation and weakening growth.
While there’s growing evidence that inflation globally is peaking, it is less clear what its trajectory is from here and where it settles. A moderation in the inflation rate due to lower energy prices and easing supply chain pressures does not mean the fight against inflation has been won, particularly with labour markets globally still very tight. We do not expect a neat and linear return to the policy environment that prevailed pre-COVID and we think the market will be surprised by inflation stickiness, both in terms of the rate of inflation and the time it takes to revert to a sufficiently low level. This will present challenges to policy makers as they adjust the policy settings and also to markets as they look to anticipate the trajectory and reaction function of central bankers.
For sovereign bonds, we think the year ahead will be characterised by volatility around the current trend as these competing pressures of sticky inflation, moderating growth and hawkish central banks plays out. We think the Fed will remain hawkish, given the reduced sensitivity of the US economy to rate rises (due to the dominance of longer dated, fixed rate mortgages). In Australia, notwithstanding the growing political pressure on the RBA, and the higher sensitivity to shorter dated fixed rate and variable borrowing, the RBA will also need to do more tightening to create the spare capacity needed to relieve domestic demand pressure.
Opportunities, despite volatility
Against this backdrop we are ‘neutral’ from a duration perspective, but do expect continued volatility in sovereign yields and opportunities to adjust duration positioning (up and down). There are opportunities in yield curve strategies. Specifically, we think the relatively steep Australian curve will likely flatten as the RBA looks to get on top of inflation, while in the US, the curve is very heavily inverted (the most since the 1980’s) and could steepen (shorter maturities outperform) as the reality of sticky inflation drags longer- dated yields higher.
We do remain constructive on higher quality credit, which presents a range of opportunities for both carry (high-quality investment grade credit) and higher returns (securitised/asset backed securities). We are more negative in the high-yield credit space where credit spreads have narrowed since September and the risks look more aligned to equities.
Our constructive view on investment grade credit comes from both the relative stickiness of credit spreads, combined with higher yields underpinned by higher sovereign yields across the curve. While we expect volatility in both credit spreads and yields, overall compensation for risk is reasonable and the premium above cash is meaningful, so we will continue to accumulate to increase the interest rate carry in the portfolio.
Optimistic while vigilant
We also like securitised credit and over the month we added 3% via an allocation to our US Securitised Credit strategy. This is expected to add additional high-quality yield to the portfolio whilst increasing diversification both in terms of geographical exposure and underlying asset type. With an average credit rating of A, close to zero duration and a headline yield of close to 8%, we anticipate the exposure will generate a high-quality yield and assist the portfolio in achieving its return target whilst maintaining its defensive stance. This has been part-funded by selling out of Asian corporates which have performed strongly since China reversed its COVID policy in the fourth quarter of 2022.
Post-month-end we also added 2% to our foreign currency exposures via the Japanese yen, which diversifies the existing 2% US dollar position. This is predominantly to increase the downside risk management in the portfolio, as the yen is typically a strong performer in a downturn. Having a mix of duration and foreign currency will assist the portfolio against rising recession risks.
We seek to continue to take advantage of higher quality yield opportunities but remain vigilant to rising recession risks.
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