Commentary: Risk of stagflation increases
Fixed income investing will continue to be challenging as we deal with multiple drivers to the level of yields. The crisis in Ukraine is causing weakness in both equity and credit markets and would typically drive yields lower, but the impact of dramatically higher commodity prices on both inflation and growth amid the start of central bank monetary policy tightening cycle is having the opposite impact. In this environment we are positioning our portfolios to benefit from flatter yield curves and have reduced overall credit exposure, with a preference for higher quality Australian credit.
Fixed income markets have delivered negative returns over the last six months as bond yields have shifted higher in response to rising inflation and expectations that aggressive central bank tightening will be required to contain it. Having been relatively steady over 2021, credit spreads (the additional yield received from lending to corporates) have now widened materially in the past two months alongside fears of central bank liquidity withdrawal. This difficult environment for fixed income assets has been exacerbated in recent weeks by the Russian invasion of Ukraine, as soaring commodity prices have escalated fears of inflation, which has kept bond yields rising, despite equity markets falling.
We have been positioning the portfolio defensively by shifting duration risk below the benchmark and reducing our credit exposure. In mid-February, when the US Treasury 10-year yield reached 2%, we started increasing duration, buying US Treasuries, and accelerated the reduction of our credit exposures. Together these moves have shifted the portfolio’s exposures in favour of safer government bonds and away from corporates, and we have built a reasonable cash reserve.
The path ahead is a highly uncertain one, given the backdrop of high inflation, war in Europe, and slowing growth. Indeed, volatility is picking up meaningfully. We expect there will be better opportunities ahead to position the portfolio more constructively, but for now are running cautious portfolio settings.
While the investment landscape is always filled with uncertainties, today’s setting is more extreme. February mostly saw moves to higher yields as economic data was strong and central banks moved to end quantitative easing. Late in the month, war tensions in Ukraine saw investors move to the safety of bonds in the fear of a broadening in geopolitical risk. Russia’s invasion of Ukraine adds both uncertainty and downside risks to the outlook for the global economy. But at this stage, the economic costs for the rest of the world appear to be relatively small. Europe is clearly more exposed. The region looks set to suffer some loss of export revenues, some banks could suffer from loan write-downs and higher energy prices will depress consumers’ real incomes even further over the coming year. For the global economy, the flow of energy from Russia to Europe and other parts of the world is probably the most critical issue. An escalation that results in a further spike in energy prices could tip part of the global economy into recession. The possibility of financial contagion from Russia to other parts of the world is also a key risk, though highly unpredictable in nature.
The US Federal Reserve’s policy is likely to have a greater bearing on the global economic outlook than the Russia-Ukraine conflict. The tightening in US financial conditions that had already started look likely to contribute to a further slowdown in both US and global growth over the coming year.
Commodity spikes poorly timed
For global central banks, the surge in commodity prices could not have come at a worse time. The initial evidence this year was that input price pressures had peaked. However, it is now likely that we will have another major wave of cost price pressures, which will increase the risk that inflation becomes entrenched – pushing the inflation peak higher and extending its duration, resulting in a faster rate tightening cycle.
The Russian invasion is likely to reinforce the European Central Banks’s cautious stance, but it’s unlikely to prevent further official rate increases from the Bank of England or the US Fed. European central banks probably face the toughest dilemma. With the peak in inflation now potentially quite a bit higher than previously thought, are Europe’s central banks really going to tighten policy amid a rising risk of recession? The ECB will now be more cautious in removing stimulus than other central banks.
With the US Fed set to begin a rate tightening cycle in March, a recessionary signal of an inverted yield curve could be close at hand. Every US recession has been preceded by an inversion of the US Treasury curve, with yields on shorter-maturity bonds rising above the yields on longer-maturity bonds. Currently the 10-year US Treasury yield is 0.35% above the 2-year yield. In the current cycle, the Fed has kept rates near zero, even with the US unemployment rate below 4% and US CPI at a 40-year high of 7.5%. The Treasury market has pushed up the 2-year yield in advance of the inevitable Fed tightening in response to such high inflation. In the medium term, we expect higher inflation to linger, driving a flatter yield curve through higher, shorter maturity yields. We are maintaining short duration positions in shorter maturities in both the US and Australian bond markets.
Inflation still challenging closer to home
In Australia, the RBA ended the last of its unconventional monetary policy settings in February, with the bond purchase program closing. The cash rate was left unchanged at 0.1% in early March as expected, with the RBA continuing to signal that they will remain patient, despite the strength in recent inflation and strong labour market data. While there are some good reasons to think that Australia does have a different CPI profile to the US, a number of the key drivers of global inflation are still at play in the Australian economy. We expect the RBA will end up tightening on a more aggressive path than its current messaging.
Since the start of the year, we have been adding exposure to longer maturity bonds, with the view they will benefit most if central banks accelerate their monetary tightening, which is likely to be followed by a growth slowdown. Recent Russian actions and the substantial global response have bought up numerous fears: a Russian economic collapse, a financial crisis, a European recession and US stagflation with soaring commodity prices. To be fair, there is already some anticipation of stagflation in the global economy that is already driving bond yields. For now, we are overweight longer-dated bonds in both the US and Australia.
We have made some adjustments to our two inflation positions: (1) reduced the inflation yield curve steepening position in the US as given the potential for stagflation the risk is that short dated inflation expectations continue to rise further and (2) added to our inflation linked bond exposure in Australia, which provides some protection against further upside in Australian inflation, particularly if the RBA remains patient and allows inflation to persist.
Credit markets uncertain
Credit markets were under pressure in February, especially toward the end of the month as the Russia military buildup moved from a threat to a full-scale invasion. Across credit markets there remain many uncertainties and the underlying credit trend may remain negative. It is likely we have moved into late cycle which is a regime consistent with negative credit returns and higher volatility. For these reasons we remain cautious on credit assets and have continued to reduce and increase the quality of our exposures. We have added more derivative protection across Australian and US investment grade credit, selling down physical credit across both Australian high yielding and US securitised debt.
Credit valuations have already moved significantly cheaper and are now sitting in the neutral range. European high yield and investment grade credit along with emerging market credit have been the worst performing credit assets. The repricing in credit spreads wider has been shorter and sharper compared to previous cycles, initially driven by concerns about a slowing in earnings after the pandemic boost, rising inflation and a Fed tightening cycle. The escalation in geopolitical risk along with its implications for higher inflation, coupled with growth concerns, will continue to put pressure on corporate spreads.
The portfolio did have a small exposure to Russia and the Ukraine (less than 15bp) via our 2% allocation to the Schroder ISF Emerging Markets Debt Absolute Return Fund. Although the bond positions suffered losses, these were mostly offset by gains on currency hedging positions in the Russian ruble. The Russian bond market is currently closed and we intend to sell down exposures when appropriate to do so.
Fixed income investing will continue to be challenging as we shift to a higher inflation environment and central banks lift cash rates from emergency settings. This transition in markets will create opportunities as fixed income becomes more attractive and more valuable as a portfolio diversifier. In the short term we are trying to protect against rising yields and credit spread widening as we navigate through this unfamiliar interest rate cycle.
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