Top 3 issues for investors in fixed income

Global bond yields moved lower over July and August on US hurricanes, ongoing Korean tensions and dovish comments from Fed Governors in light of subdued inflation.  The outlook improved in the month of September amid the deferral of the US debt ceiling issue, better than expected data (including CPI prints), a higher oil price, an easing in geo-political concerns and the release of the Trump tax plan cut.  Yields did move up a notch (particularly at the front end of the Australian curve) as some better than expected economic data (employment, GDP and investment) saw the market bring forward expectations for RBA tightening from early 2019 to mid 2018.

So far this year fortune has favoured the bold. The further out the fixed income risk curve you’ve positioned, the more lucrative the returns.  Both high yield and investment grade credit have benefitted from continued risk appetite and further spread compression.  Bond yields have waxed and waned but in broad terms have not changed markedly from where they started the year.  Volatility has been virtually non-existent – the ride has been smooth.

I think I’m one of the only Australians who has never been to Bali.  There’s no particular reason for this but it’s just never been on my holiday list.  Recently Bali hit the headlines due to the potential eruption of the Mount Agung volcano and the evacuation of more than 130,000 people living around the volcano’s crater.  Increased seismic activity over recent weeks has been a handy precursor to an impending eruption and while no doubt inconvenient, it has allowed residents to get out of danger.  At the time of writing though no eruption had occurred and the focus of media attention had shifted to the negative impact of the volcano warnings on tourism.  Damned if you do, damned if you don’t.

This increase in seismic activity is in stark contrast to the lack of volatility in key financial markets. Unfortunately financial markets rarely provide the same warning signs as active volcanos.  That said, the fact that market volatility is low does not mean we can stay relaxed and comfortable, but nor does it necessarily presage calamity.  This is because markets are enjoying a cocktail of somewhat synchronised global economic growth, positive but low inflation and central banks with their feet still well and truly on the accelerator – even if some have eased off just a notch.  This is a potent mix and one that typically correlates with strong markets and low volatility.

In the absence of an equivalent increase in “seismic activity”, the critical issue for investors today is what breaks this cycle.

In my view there are 3 critical and interconnected things to look at:The first is valuations.  We know that valuations are crude tools in the short run but as our time horizon extends so too does their worth.  Valuations tell us that markets are extended having in many cases discounted future returns into current prices – not that unusual to be sure, but clearly helped along by policy makers’ intent on distorting the pricing and allocation of risk in the economy.  This is true for both bond and credit markets where risk premium continue to narrow.  What this tells us is the base is shaky. To extend the volcano analogy – pressure below the surface is building.

The second issue is inflation.  Despite flirtations with deflation and reflation, inflation globally has remained benign due largely to the overhang of capacity in both labour and product markets.  However this excess capacity is disappearing.  At the pointy end is the US labour market which has gradually tightened.  The relationship between inflation / wages and the unemployment rate is non- linear which means that inflation responds more substantially when the unemployment rate falls significantly below the NAIRU.  Current estimates have the NAIRU at 4.7% (albeit there is a range of estimates) compared to a current unemployment rate of 4.3%.  If this trend continues we would expect inflation to respond.

The third is central banks.  The response of central banks to rising inflation, starting with the Fed, is what I think will ultimately lead to a repricing of risk in markets.  The mismatch between rates and nominal growth in the economy is still significant meaning there is plenty of scope for rates to rise.  Importantly, this would matter less if valuations were more supportive, but arguably extended valuations heighten the risk that even smaller changes in policy can have a disproportionate impact on asset risk premium.

The above framework is highly relevant to our current thinking and reflected in portfolio strategy.

Compared to benchmark we remain short duration – primarily in Europe where the level of yields remains low relative to economic conditions, and in the US where the cycle is most advanced, official rates are on the rise and where the Fed has taken concrete steps to start to slowly shrink its balance sheet.  Our comments above about an anticipated rise in US inflation in response to a declining unemployment rate are relevant here.

We do not have a lot of credit exposure in the portfolio at present.  The main reason for this is simply that spreads have narrowed a lot.  Further spread compression is difficult from here meaning the risks to corporate bond returns have become more asymmetric (with a downside skew).  We have not moved underweight credit yet, partly because credit has such a low weight (10%) in the benchmark, but also because the macro-economic and policy backdrop remains favourable (for now).  That said, as noted above things can change quickly and we may not get the seismic warning signs before things start to get interesting.  Better to be prepared.

Outside this we are looking to generate returns through opportunities in inflation, yield curve and cross-market positioning.  We have increased our exposure to reasonably cheap inflation protection via Australian inflation linked bonds, and are also progressively positioning for a flatter domestic yield curve.  While each of these help prepare for a turn in the local policy cycle, we still expect small outperformance of Australian vs global bonds as the global reflation story seems to be entering its second chapter.

Over the quarter we have also been focused on adding more ‘yield’ into the portfolio.  Value has re-emerged in several sectors – semi government bonds and RMBS.  Semi government curves have recently steepened on concern over weaker fiscal outlooks and a bigger funding requirement for the AAA names, making spreads and yields in longer dated semi government bonds more attractive.  Australian RMBS has lagged the spread tightening of other credit sectors, despite relatively stable employment conditions that have underpinned the low levels of arrears and losses in Australian RMBS pools, and is now the best value on the bank capital structure.

Overall, positioning remains cautious awaiting an increase in volatility and repricing that will allow us to position more constructively.