Markets pre-empt economic recovery
December was another strong month as fixed income investors continued to look ahead to the economic recovery. But by factoring future good news into today’s prices, valuations in some segments are becoming stretched thereby reducing upside when events actually transpire. We are responding by repositioning the credit exposures in the portfolio, adjusting our foreign currency exposure and reducing our duration exposure to keep the portfolio diversified and defensive.
After a standout November, markets experienced another favourable month in December. Equity markets and the Australian Dollar continued to rally, while credit spreads continued to compress. Despite COVID-19 concerns – particularly in Europe and the US, where the number of new infections each day remains high – market sentiment is positive. Investors know that the COVID-19 vaccinations are coming and they're looking six months down the track for the recovery to start taking hold.
In Australia, retail sales and GDP have improved, signalling the beginning of the recovery. Investors appear confident that central banks will continue to offer liquidity and support, keeping rates low for a very long time, and governments will continue to offer policy support through payments to consumers or to unemployed people. This ongoing policy support will be critical to the recovery, even as it is gradually reduced over time.
Low yields and high market prices look set to remain
Investors’ confidence in the safety net provided by low cash rates and government policy support is allowing them to look through the current concerns. This potentially creates a problem as they're bringing forward much of that good news into current market prices. So, during 2021, when positive events transpire and we have evidence that things are improving, this will largely be factored into the market. As a result, equity prices are moving into overvalued territory with an expectation of higher earnings from companies to come. On the credit side, investors are reducing the risk premiums in spreads as they're seeing future earnings supporting companies and lowering the potential for defaults.
Investors are also searching for higher yields with cash rates and sovereign bond yields approaching zero. This is pushing many of them out the risk spectrum of fixed income and credit markets to try and capture higher yields, which is driving demand for income and supporting the market. This is unlikely to change any time soon. Central banks have been very clear they want to keep yields low to support economic recovery, which, in turn, supports the current high market prices. However, once policy support reduces and then eventually ends, we can expect yields to rise and prices to fall.
Turnaround for transport and real estate sectors
The best performers over December in the fixed income market were the higher risk, lower credit quality assets. Both the carry from coupons and capital appreciation from spread compression drove returns. Investment grade securities also performed but have less carry and experienced less spread contraction from tighter levels. Subordinated securities, which are lower in the capital structure, also performed well.
In terms of sectors, we saw positive performance from sectors that struggled in 2020 due to COVID-19 restrictions – namely transport and real estate. Positive news on the vaccines means these sectors can expect to generate greater earnings. Their spreads came in more aggressively than other sectors that had already done quite well, but who were less affected by the lockdowns.
Our portfolio position
Over the last three months, we have added to high yield at the margin to boost returns. We still see credit spreads as being well supported due to the policy background and promise of recovery. We remain invested in liquid securities and are highly diversified across borrower types, sectors and regions. Our Australian and US credit exposures are supplemented with exposure to US securitised credit, emerging markets debt and Asian credit providing diversification and access to higher yields.
We expect less capital growth going forward as we have had in the last six months. Capital growth comes from yields falling and credit spreads contracting which drives prices up. Whilst markets have to some extent forward loaded returns on the expectations of the recovery in 2021 and 2022, we still expect to see credit spreads coming in but to a lesser extent as we move towards expensive territory.
We use interest rate duration as a diversifier in the portfolio as interest rates tend to fall when economic recovery falters. Under current conditions, we are becoming concerned that duration won't provide the hedge it has previously. This is partly due to the actual level of yield being so low, but also because we're seeing yields rise at the longer end of the maturity spectrum – particularly in the US. In December there was a small rise in US yields, and in the 10 year plus part of the curve in Australia, which is where we usually have our defensive duration. In anticipation of the Democratic victory and concerns about the Senate runoff in the US, we lowered duration in the portfolio over December. There is more chance of greater fiscal stimulus in the US with the Democrats holding the Senate, and that’s not supportive for longer term interest rates in the US. Increased inflationary expectations will make the defensive component of the portfolio less effective, so we have reduced our duration exposure.
The other defensive mechanism we use to protect the portfolio is foreign currency exposure. We maintained this exposure during December, despite the Australian Dollar rallying. When credit spreads expand because economic recovery is faltering, or we experience new COVID-19-related issues, we can expect the Australian Dollar to weaken in those periods. This then provides favourable performance offsetting potentially unfavourable performance on the credit side of the portfolio. This is why we maintained our foreign currency positions during the month as a defensive diversifying part of the portfolio.
Outlook and strategy
While valuations are moving towards expensive territory we’re looking to trim the amount of credit risk in the portfolio. With the market looking so far forward and pre-empting the economic recovery into current pricing, we don’t expect to see as much of a benefit to the portfolio when the recovery actually happens.
To counter our concerns about the longer end of the yield curve in the US being impacted by more Democratic fiscal spending and increasing inflationary expectations, we may also continue to trim duration while offsetting that position with foreign currency exposure – predominantly in US Dollars and Yen. This will help to lessen the impact on longer maturities in Australia and overall portfolio performance.
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