Plotting a path through the fixed income uncertainty

The global economy is undergoing arguably its sharpest contraction outside wartime. The numbers, like the virus itself, are moving quickly, but latest estimates are that the plunge in global activity in Q2 will be in the order of around 30% of global GDP. Not only is this drop staggering in magnitude, but it has come at breathtaking speed.

The human costs of this tragedy are clearly devastating. Poor preparedness, initial slow action and lack of equipment in some places have been contributors. In the absence of a vaccine, the main medical response has been to ‘flatten the curve’ of the incidence of infections. This necessary response to the health crisis also comes at huge economic cost. Social distancing, mobility restrictions and eventually lockdowns are devastating a swathe of service industries, from travel to education, hospitality and retail, with unemployment rates set to soar as these sectors shed variable costs, mostly labour. A related complication is the collapse of the oil price – bringing both pain for high cost producers, including much of the burgeoning US energy industry, and a new layer of geopolitical complexity as the Saudis and Russians face-off over production cuts.

The market response

There are several key dimensions of uncertainty in the evolving crisis. The range of negative outcomes is wide – wider than in the GFC – because of the health and social order impacts. There is a terrible trade-off between the health and economic costs that governments must weigh. And for markets, as this is primarily a medical emergency, few analogies from the past are relevant.

Markets rioted in the early weeks of March, reflecting both the likely magnitude of the economic downturn and the heightened uncertainty. Volatility was extreme and liquidity in many assets was virtually non-existent, even in government bonds. Aside from US Treasuries, a beneficiary of flight-to-quality as well as the Fed’s rate cuts, few assets delivered positive returns in March.

Markets have settled down to a degree, in part because in the developed economies at least, the economic policy response has been relatively swift. Perhaps prepared by the experience of the GFC, both monetary and fiscal policymakers have reached deep into their toolkits in an attempt to ‘provide a bridge’ for the private sector until the health crisis is brought under control. The Australian government’s fiscal response to date includes spending adding up to a total of roughly 12% of GDP, while the RBA has cut rates, begun buying government bonds to keep yields low and help improve market functioning, and provided cheap access to funding for banks.

Putting a price on uncertainty

The policy response is designed to save jobs, and in some cases whole industries. However, while there are also clearly some sectoral winners – medical goods makers, supermarkets, communications – and some good stories of adaptation, like Detroit’s auto makers switching to produce ventilators, policy actions won’t save everyone. Unemployment rates will jump dramatically (to perhaps 8% in Australia, and higher elsewhere), profits will decline materially (30%–50% in aggregate), dividends will be cut, businesses will fail and corporate bonds will default.

With still great uncertainty about the magnitudes of these outcomes, interpreting to what extent markets are priced for them is difficult. Clearly the economic outlook has deteriorated, but given the pricing shift, has value appeared? Economists like to talk about the shape of recovery – whether it’s a V, W, U or an L – but much, it seems, depends on how long the economic shut-down runs for. Not long enough, and infection rates will rise again, forcing another shut-down; too long, and the second-order effects of the shut-down will be exacerbated, including higher unemployment reinforcing falling demand. In this environment, it’s clear that investors should be demanding an additional premium for uncertainty.

In our view the world was already in a weakened state before COVID-19, largely because the debt build-up fuelled by stimulatory monetary policy had largely run its course. The doubling down by central banks providing stimulation during this crisis is likely a last hurrah, before the baton passes more permanently to fiscal policy to provide the main counter-cyclical support to the private sector. Other large shifts will emerge from this once-in-a-hundred-years shock – potentially including a larger retreat from globalisation and re-nationalisation of some industries.

The implications for fixed income markets

With bond yields already close to record lows prior to March, rates markets had to a degree already priced in the looming weakness, certainly relative to the optimism of riskier assets. This may help explain why longer-dated government bonds, other than Treasuries, were unable to rally in March. Poor market liquidity and a demand for redemptions from fixed income were also factors. From a wider perspective, it does suggest that at low yields, even duration-based fixed income is better seen as a lowly-correlated diversifier of risky assets, rather than a hedge.

Our rates outlook from here is one of competing forces. At 0.50%–0.75%, bond yields in the US and Australia are low and much supply is coming in order to finance fiscal spending. On the other hand, economies are weak, and in the short run central banks are buying at least as much as governments are issuing.

Credit is where the greatest opportunity and the greatest danger lies. Having high corporate sector debt levels in the US was a bad starting point – a whole range of downgrades, restructurings and defaults are likely. Strong balance sheets are likely to be rewarded, as are companies with sufficient operating flexibility to survive the cashflow crunch (those with low fixed costs relative to cashflows). Banks are relatively well capitalised, and credit holders will benefit from moves to restrict dividends, but they are also being pressured to prioritise helping governments keep corporates and households afloat, at the expense of profits. We have stepped up our analysis of downgrade and default risk, alongside market liquidity risks affecting individual names.

Our portfolio position

We were relatively well positioned coming into this crisis, being overweight duration, particularly in the US, and avoiding global and lower quality credit. Through January and February and into early March we were increasing portfolio duration, to a high of 1.3 years longer than benchmark, with exposures concentrated in the front of yield curves where central banks had room to ease – notably the US but also Australia and Canada. Similarly in January, February and early March we were paring back our credit exposures, mainly trimming our overweight position in Australian investment grade credit.

As the month of March progressed we further adjusted exposures in light of the rapid developments. With central banks cutting rates to zero (or slightly above), we took profits on our long duration positions in short tenors. As well as reducing overall duration to about 0.5 years longer than benchmark at month end, we reconfigured our yield curve exposures to position mostly in the mid-part of curves, where central bank buying is likely to be concentrated. Relative to benchmark, we now see better opportunities in credit than in rates.

With credit spreads widening meaningfully in March, we have rebuilt our credit exposures moderately, by allocating predominantly to the assets that have re-priced most aggressively. This includes small allocations to both global investment grade corporates and Australian sub-debt, and taking profit on our long-held short position in US high yield. We’ve also allocated back a little to Australian investment grade credit, our preferred corporate exposure in this environment for its high quality. These allocations have been partly funded by selling down our Australian government and semi-government exposures. Australian mortgages remain attractive for their sound fundamentals, and we also maintain our allocations to US mortgages and emerging market debt, seeking to diversify both income and risk sources.

The portfolio retains its high quality and liquidity features. We are mindful of retaining these features when considering the extent to which we rebalance the portfolio towards the opportunities that have emerged. As the extent of the economic damage and the (likely protracted) nature of the recovery become clearer, we expect to continue to tilt the portfolio towards more attractive assets. This environment should reward our active approach and risk focus.