Commentary: Shifting to a more volatile investment environment
High inflation in 2022 and the central bank response has resulted in a new investment regime, where economic risks have increased and there is higher risk of recession and higher default risk. This requires more active management of duration and credit risks and a greater focus on issuer selection.
March has been another challenging month in markets. We continue to believe we are in a transition phase, during which the central banks are adjusting monetary policy settings from excessively loose to settings which are more appropriate for the level of inflation. The size and pace of monetary tightening has resulted in stress in the financial system, particularly the banking system, wherein banks are more susceptible to failure as potential asset/liability mismatches arise. This was the case as we witnessed a run on deposits with Silicon Valley Bank (SVB) and Credit Suisse, which then required regulators to step in to prevent contagion across the entire banking system.
The response from regulators was swift, providing liquidity to offset deposit losses to deal with SVB and Credit Suisse and avert a GFC mark 2.0. Our base case is that the current stresses in the banking sector do not morph into a full blown banking crisis. The rapid rise in rates has, in our view, resulted in a liquidity crisis for the banks but not a systemic solvency crisis. That said, a material deterioration in the asset side of bank balance sheets (i.e. loan quality deterioration) would be highly concerning.
With the banking system crisis seemingly averted, at least in the near term, the market’s focus has reverted to the tension between inflation and growth and the reaction function of the central banks. With the reemergence of inflation for the first time in decades, the playbook of central banks has arguably changed as their flexibility to respond to crisis is constrained. No longer able to aggressively cut rates at the first sign of stress they are forced to navigate a more difficult environment, balancing off inflation and growth. This is likely to see a stop-start approach to interest rate policy as we witnessed with the Reserve Bank of Australia in early April, where policy was unchanged but they also warned that this did not mean the tightening cycle was over.
A new investment regime
We believe we are heading into a different investment regime than we have been facing over the previous decade. The past 10 years have been marked by very low inflation, very low interest rates and low macro-economic volatility. Central banks flooded markets with liquidity by buying both sovereign and lower risk credit assets, a policy known as quantitative easing. This resulted in very low credit risk premia as investors were forced to chase higher yields with less regard for credit risk; those credit managers that invested at the higher risk end of the spectrum were rewarded with very strong relative returns.
High inflation in 2022 and the central bank response has resulted in a new investment environment, where economic risks have increased and there is higher risk of recession (with higher default risk) and higher uncertainty over growth and inflation outcomes, resulting in higher market volatility. In this environment it pays to build robust, liquid and defensive portfolios that diversify across multiple risk premia. As such, investors should be favouring income strategies that are: 1) diversified across risk premia (primarily interest rates and credit); 2) diversified across region, industry sector and asset type; 3) invested in liquid assets with transparent pricing; and 4) actively managed to enable shifting of portfolio allocations as valuations and risk change.
We believe that the Schroder Absolute Return Income Fund is well placed to manage through this change in regime. Firstly, with a duration range of -2 to +4 years we have significant flexibility to manage the level of interest rate risk in the portfolio and avoid structurally long duration settings. We expect much higher inflation volatility and it will pay to be active and flexible in managing interest rate risk by varying the total portfolio duration exposure. The recent experience in 2022 of very negative returns in government bonds as yields increased reinforces this.
Quality always matters
Investment grade credit will remain a key exposure for income funds, but managers will need to discriminate between issuers. The yield premium over government bonds will provide income, however individual issuer selection and sector selection will be increasingly important, particularly in periods where lending standards are being tightened. Identifying businesses that have high-quality cash flows and a business model that benefits from higher inflation will be important. Tighter credit standards will see some businesses face refinancing difficulty and hence default risk will rise; the importance of picking the winners and avoiding the losers in a market with asymmetric payoffs will rise. Investing in high yield (lower quality) credit will require even higher levels of valuation support (i.e. higher credit spreads) to provide an additional return to compensate investors for default risk, particularly as recession risks increase. This suggests tactical exposures to high yield credit – when valuations provide a high level of support – are the most appropriate way to manage exposures to this asset class. A structural exposure or buy and hold approach is, in our view, not advisable.
Foreign currency exposures will continue to be an important component of the portfolio. The Schroder Absolute Return Income Fund is atypical among its peer group, with the flexibility to hold up to 10% currency exposure. This is important as it provides an additional lever to add diversification and help manage and insulate the portfolio from downside risk in credit exposures, but can also be a source of return. For example with the rising risk of recession, the US dollar and the Japanese yen typically perform well against the Australian dollar. Furthermore as we move from the coordinated global easing cycle of the past decade to more divergence in policy from central banks, cross currency opportunities are expect to emerge as a source of return.
Overall we remain defensively positioned and our globally diversified and active approach will allow us to be flexible and take advantage of opportunities as we navigate the period ahead. Over the quarter we have deployed cash into high quality credit while also adding duration risk. Our liquid and high-quality credit bias should continue to protect capital and provide a defensive income stream with a current distribution rate of 4.5%pa, paid monthly.
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