The US economy remains solid. Unemployment has finally moved down through 4%. Trump’s tax cuts are kicking in, sending growth back up to 3%, an elongation of an already very long recovery cycle. Inflation is gradually lifting. The Fed continues to tighten.
There have been few negative feedbacks from higher rates to date. US housing and business credit have held up well. Financial markets have broadly taken tightening in their stride; high yield bond spreads remain close to lows and equities near highs.
However, compared to last year, 2018 has been quite a different year so far – risk appetite has stalled and volatility is higher. The US dollar, key to global liquidity and lifeblood for much of the emerging world, has started to appreciate again as European fortunes have ebbed, signalling emerging market trouble. Compared to the fragilities that emerged in similar circumstances in 2015, however, the oil market and China appear relatively stable.
In the global economic narrative, synchronisation has given way to divergence. Mostly this means that the US has lifted while Europe has decelerated, the opposite to what was happening a year ago. This shift was already apparent in recent data but the Italian political saga of the past few weeks will likely reinforce it. However, despite the reminder this episode has provided about the complexity of the monetary union, given political independence of member countries, the European economy remains in a reasonably healthy cyclical position. We expect a continued gradual reduction in ECB support.
The Australian recovery remains on a similar trajectory to elsewhere – slow and extended – but relative to the US a few years lagged. We’ve being having internal debates on the timing of rate hikes by the RBA and conclude that tightening, when it comes, will be gradual. This leaves Australian assets on the whole relatively more appealing than elsewhere.
Markets are happily priced for a Fed that tightens back to neutral but not beyond. The risks are in both directions, but to us the more likely surprise is that stronger growth and especially more inflation requires further tightening. A move to tight policy would likely be difficult for markets, precursors of which we are probably already witnessing.
Drawing these themes together, we remain cautious in our portfolio settings. Bond valuations, particularly in the US, have improved as yields have risen this year. However, the cycle remains firm and with output gaps closing globally, inflation and policy tightening will follow, suggesting further cyclical underperformance of bonds. Credit risk, meanwhile, is priced for a healthy economy — cyclical fundamentals are supportive, but valuations are extended. This environment may prevail – especially as in our view recession is still some way off – but the skinny margins for earning carry warrant a defensive stance.
Duration relative to benchmark stands at 1 year shorter than benchmark. While this remains a significant relative position, we’ve taken advantage of yield rises year-to-date to trim the short from 1.7 years earlier in the year. Despite persistent underperformance, and hence improved relative valuation, the US Treasury market remains our preferred underweight given our earlier comments about the Fed. We are also short in Europe where valuations remain rich but we’re cautious on the size of our position pending more concrete evidence the ECB is prepared to tighten policy, and in Australia which is little priced for a possible lift in the cycle. We’re moderately positioned for the yield curve to flatten in each of Europe and Australia to capture policy-driven increases in short-dated yields, and we also have in place explicit inflation protection in both the US and Australia via inflation-linked bonds.
Our credit exposure is modest in absolute terms and about neutral relative to the benchmark. Having added back a little to domestic investment grade paper, particularly in floating-rate form following weakness in March, at the end of May we neutralised our small overweight to benchmark using index credit default swaps. We continue to prefer Australian credit to global for its high quality and short tenor, though global investment grade credit is starting to look attractive in a relative sense given its underperformance so far this year. Our small global and higher yielding (riskier) exposures are effectively hedged.
Altogether this leaves the portfolio well placed to deal with the transition to a market environment involving higher yields and higher volatility. Being cautiously positioned now allows us flexibility to position more constructively as this occurs.
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