The lack of inflation is a global issue

Well the Balinese volcano didn’t blow and neither has volatility in markets. In fact, key market measures of implied volatility continue to plumb new lows. Contributing to this is the synchronised nature of the global growth uplift, and the very clustered expectations of economists that macroeconomic stability will prevail. 

The macro stability cocktail is a combination of decent growth, muted inflation and very gradual withdrawal of central bank accommodation. Muted inflation is constraining the pace of tightening which together with stronger growth is supportive for most assets. While valuations continue to stretch, for now there’s no trigger for repricing - it remains a low yield yet carry friendly environment.

The lack of inflation is a global issue. Unemployment is at cyclical lows in the US, Germany and Japan yet in each of these countries there is only small evidence that wages are picking up. No doubt globalisation and technology are common factors that have helped constrain wages across countries. The desychnronised nature of the recovery until now has also capped inflation in countries whose currencies have appreciated on cyclical outperformance. From here, however, common global uplift should help neutralize some of these inter-country effects, and allow domestic conditions to play out more powerfully.

Central banks have been puzzled by the lack of inflation, but have not stepped away from its management as the primary goal of policy. However, they’ve responded to the way QE’s impact has been much stronger in financial markets than the real economy by making financial conditions a larger part of their thinking, even if they’ve not formalised this in policy frameworks. With inflation projected to lift and financial markets strong we expect central banks to continue to gradually tighten.

Year to date, bond yields have drifted lower and curves flatter, while credit spreads have continued to tighten. Valuations of fixed income assets have moved further into expensive territory with few exceptions. Term premium is close to historic lows and credit spreads at post-GFC tights. Given this backdrop our process continues to suggest defensive positioning remains appropriate until better value is restored. We see higher inflation and/or a faster pace of policy tightening as possible triggers.  

Accordingly, portfolio positioning remains cautious along both interest rate and credit dimensions. In rates, we’re holding about 0.85 years less duration than the benchmark. While this aggregate position has been little changed over recent months we’ve shifted the country composition, by first buying back into weakness of Australian bonds triggered by excitement over possible RBA hikes, then selling back down following outperformance. This leaves the aggregate relative to benchmark position distributed equally between short duration positions in the US (where the cycle is most advanced), Europe (where valuations are most extreme) and Australia. We’ve also shifted our exposure slightly flatter along the Australian yield and have marginally increased our inflation linked exposure to help position for an uptick in the domestic cycle.

In credit we hold a very modest absolute exposure, a little above the benchmark weight. During October we added a little back to domestic investment grade credit, at present our preferred fixed income asset for its high quality and short duration. Our exposure to lower quality domestic and global credit remains limited. We’ve also recently marginally topped up exposures to longer-dated semis and to AAA RMBS, which have lagged the spread tightening of other sectors.

Altogether this positioning is defensive as we await the triggers for market volatility that should provide the opportunity to position more constructively. Until then we remain patient and true to process.