Defaults delayed, not defeated
As a second wave of COVID-19 rolls around the world, both consumers and corporates remain under pressure. A flood of liquidity and prompt government action have successfully delayed many defaults, but that does not mean the default cycle is over. Having benefitted from the recent rally in credit markets, we believe it’s important to remain active, defensive and liquid while the pandemic plays out.
In last month’s commentary, we touched on the apparent worsening of the COVID-19 pandemic in the US and the expectation that some sections of the country were experiencing a second wave. Roll forward a month and Australia now has its own challenges. With Victoria having just gone into lockdown as case numbers increased significantly, it is clear the health crisis is far from over.
While there are some potential glimmers of hope around a vaccine, with several potential candidates moving into later stage trials, uncertainty continues, and the ability to test, approve and distribute a vaccine globally seems some time away. The World Health Organisation has even come out recently suggesting we may never find a vaccine. In any case, the virus challenges persist and are likely to continue to affect economic activity.
On the economic front, early indicators show labour markets stalling and unemployment rates remaining high, while the income picture for the consumer looks particularly concerning. Government fiscal transfers have limited job losses and supported income, yet almost all of these measures are short-term in design, with various components set to expire over the next few months. The key question for markets is whether fiscal policy will remain stimulatory to support the ongoing recovery.
Testing the limits of government support
One interesting aspect of the current crisis is the low level of defaults coming through credit markets. Quite clearly there is a high level of stress in the corporate sector, which we can observe through falling profits and cashflows, lower margins and the number of businesses closing. While there are some winners in the current situation, there are large segments of the economy which are struggling.
Many corporates went into the crisis with elevated levels of leverage as money was relatively cheap and freely available. To date, this access to capital has remained intact. This is clearly observed in the US, where the various stimulus packages from the government have ensured there is no withdrawal of liquidity. This allows businesses that were in trouble to continue to trade, which effectively gives those businesses some option value to hopefully ride out the storm, get to the other side of the crisis and continue to function once life returns to normal.
There is a practical limit to how long this can last. For example, in Australia, temporary changes in the application of the rules allowing companies to trade while insolvent has arguably helped delay some businesses moving into the distressed phase and hence default. An expiry of this relaxation of rules could be significant.
Our portfolio position
While there has been a lack of defaults, we believe it is purely a delay, rather than a cancellation of the default cycle. We anticipate the worst of the default cycle to be in front of us and hence we remain defensive and continue to hold high quality credit assets across the globe. This allows us to deliver income from coupons and assists in preserving capital.
Over the month we made some small adjustments to credit exposure in the portfolio. We reduced our allocation to higher yielding Australian credit on the view that prices had rallied strongly and that we may see some price weakness, given the pressure on asset values coming through bank balance sheets. At the same time, we reduced our global high yield short position to a neutral stance. This was largely driven by a desire to reduce some of the carry costs of being short the asset class in this environment, where it would appear that the liquidity-driven price momentum may continue over the short-term.
While we have reduced our short position, we have not taken a long position, given the concerns around valuations and potential volatility should oil markets weaken or the broader market begin to price in the fundamental challenges facing the US economy. Overall, our exposures remain focused on higher quality assets.
In terms of duration, we retain a long duration position of close to 1.9 years. This is predominantly split between Australia and the US. We do believe duration still has a role to play in portfolios, although we are cognisant that the effectiveness of duration is challenged in an environment of low rates and yield curve control. We expect any sell-off in bond yields to be muted. As such, we are currently holding the duration positions for some carry, but also to provide some downside risk protection in the more extreme scenario of a risk-off phase.
In terms of currency, our long USD versus AUD position has been a drag on portfolio performance, given the strengthening Australian dollar. We believe currency can continue to provide downside risk management benefits to the portfolio, and that holding duration combined with currency remains an effective method of maintaining downside risk protection despite detracting at the portfolio level from time to time. Arguably, in a scenario where credit has performed well, we are comfortable carrying some costs at the portfolio level for the insurance policy we believe the currency position can provide.
Looking forward, we remain convinced that a defensive portfolio position is warranted. The recent liquidity-driven rally in risk assets looks to be disconnected from the fundamentals in many companies and businesses. As such, we retain high levels of cash for the purposes of portfolio liquidity and also retain our defensive bias, with exposure predominantly to investment-grade credit. We continue to seek diversification through our Asian credit exposures, our US securities exposures, and our emerging market debt absolute return focused portfolio, along with our currency and duration positions. Overall, we remain active, defensive and liquid.
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