Markets take pause, awaiting the next move from central banks
While we expect growth to remain robust and inflation readings elevated, there are also signs that bond market expectations have over-reached themselves. With prices rallying and yields retracing around half of the rises seen in Q1, the market seems set to enter a period of consolidation while central banks around the world unveil what is likely to be a very elongated path of policy withdrawal.
The key events for global fixed income markets in Q2 were the extremely strong monthly US CPI data, and more hawkish commentary from the US Federal Reserve (FED) at its June meeting. At face value, both events should have been bad for bond prices (driving higher yields), yet longer-dated government bond prices were broadly range bound in April and May, before rallying strongly in June, retracing approximately half of the sharp rise in yields seen over Q1.
This apparent about-face is probably an example of bond market expectations getting ahead of themselves. Bond yields jumped sharply in Q1, reflecting a stronger recovery than previously anticipated. However, alongside the bond move, expectations for growth and inflation were revised up further. With expectations already high, the expectedly strong Q2 data failed to move bond yields higher, and have made yields vulnerable to a move lower if there is a deceleration in the recent growth pulse.
We expect growth to remain robust and annual inflation readings to remain elevated, but we’ve likely seen the peak in data momentum. Hence, we believe central banks are the most likely driver of renewed bond market weakness (and higher yields), since emergency policy settings need to be re-aligned to reflect the better growth outcomes and prognosis. However, expectations for policy realignment are also high – meaning that a repeat of the “taper tantrum” is unlikely – with central banks carefully messaging a very slow retreat.
The Reserve Bank of Australia (RBA) is a case in point. It has surely overcommitted by effectively promising not to raise the cash rate until 2024 – in spite of the unemployment rate falling back to 5% and record increases in house prices. Yet time is on its side, having tied rate hikes to a persistent uplift in inflation, which still remains some way off. The inflation issue is more pressing in the US, yet similarly the FED wants to see higher inflation persist before it removes the punch bowl more meaningfully.
Spreads on key credit assets such as US high-yield bonds have tightened to historic extremes, driven by the improved macroeconomic backdrop and strong demand for assets in a low-yield but high-liquidity environment. However, with a deterioration in corporate fundamentals – due either to a fall in earnings or a re-leveraging of balance sheets – still some time away, riskier asset revaluation also appears very closely tied to central bank stimulus withdrawal.
This all suggests that we will see consolidation for a few months while the data plays out and central banks consider next steps on what will likely be a very elongated path of policy withdrawal. We continue to expect that bond yields will eventually move higher as the uptick in inflation runs longer and central banks slowly shift cash rates up. But higher yields – should they eventuate – are not to be feared. Firstly, probable yield moves are likely to be limited, and secondly, higher yields improve the strategic attractiveness of bonds as diversifiers. With yields already materially higher than last year, fixed income assets are already better value both in absolute terms and relative to expensive equities, but are not yet cheap.
Positioning for the consolidation phase
Key elements of our current positioning for this consolidation phase include owning higher quality investment grade credit, positioning in longer maturity securities that provide higher yields due to the steepness of the yield curve, capturing country-specific relative value opportunities, and maintaining the discipline to position the portfolio against shorter-term, sentiment-driven moves.
We have moved portfolio duration longer. Including recent changes in early July, we are now about neutral to benchmark. We retain a short position in the US, where the upside cyclical pressure is greatest, but now prefer longer duration in Australia, which offers value, particularly in longer maturities, and in Canada, where several official interest rate increases are already priced in. We continue to prefer strategic yield curve flattening positions, but have taken partial profits on these positions in Australia and the US after a significant move in late June. We have also converted our inflation-linked bond position into a relative one – positioning against market consensus. As a result, the portfolio will benefit from a fall in inflation expectations in the US in the short term, relative to longer-term expectations. In addition, the portfolio continues to hold relatively cheap Australian inflation-linked exposure.
Our most recent credit allocation change was to add back to Australian investment grade credit, emerging market debt and Asian corporates, following the underperformance in the early months of the year. In spite of negative valuation signals, we maintain a moderate exposure to credit, focusing on earning high-quality income. We prefer Australian investment grade for this purpose, while exposures to US securitised, Asian and emerging market debt help to add diversity. We hold hedging positions in US investment grade and US high-yield securities through derivatives, given extreme valuation readings and credit spread sensitivity to shifts in FED policy. Exposure to Australian mortgage securities has also been reduced as spreads narrowed.
Our research analysts continue to work hard to unlock value at the security level. A particular focus recently has been quantitatively capturing ESG data relating to each of the issuers in our investment universe. We also are preparing to expand our portfolio reporting to cover relevant ESG metrics.
The experience of 2020 and 2021 to date has showcased the value of active management in fixed income. We expect active management to continue to be extremely important as markets transition to a post-COVID “normal”, and believe we are well positioned to navigate this new investment environment.
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