Vulnerable consumers face fiscal cliff
With developed economies losing momentum as COVID-19 cases rise, the key question for markets is whether fiscal policy will become contractionary while the recovery is still fragile. In this environment, lower quality corporate bonds remain vulnerable, with valuations outpacing fundamentals. We will continue to seek income-generating opportunities around the world, while avoiding the all-too-apparent risks of a finely balanced global economy.
As the global economy continues to emerge from its deepest recession in decades, some parts of the world are dealing with an increase in virus cases as economies start to re-open. Ultimately, the rise in cases will affect economic activity, and precedents from earlier in the year suggest that rising cases can significantly lower activity. But that link between rising cases and economic activity has changed. Real-time evidence from the New York Fed’s weekly economic activity index seems to suggest that rising COVID-19 cases in the US have not led to a significant inflection in economic activity as they did earlier in the year.
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Our view has been that developed economies were likely to lose momentum after the initial strong bounce in May and June signalled by early readings of Google mobility data and daily hours worked, followed by weaker official data on consumer confidence and unemployment claims or benefits.
Consumers vulnerable as support falls away
With early indicators showing labour markets stalling and unemployment rates remaining high, the income outlook for the consumer looks particularly concerning. Government fiscal transfers have worked in the early stages of the crisis to limit job losses and support income. Yet almost all stimulus measures and credit support programs globally have been designed as time-limited, with the expiry of various components over the next few months converting the largest global fiscal thrust in history into the largest drag.
This is the key question for markets – will fiscal policy turn contractionary or remain stimulatory to support the ongoing recovery? It does seem an absurd policy dilemma to face when business cycle recoveries are early-stage, unemployment rates very high and long-term financing costs are at record lows.
Unconventional times call for unconventional measures
As governments try to immediately extend unemployment benefits, central banks are considering the possibility of more monetary easing in the form of unconventional policy. Even though it feels like we have reached the end of the road for monetary policy dominance, central banks are likely to move further down the path of outcome-based forward guidance, even more aggressive balance sheet expansion, and yield curve control to drive down term premiums to support the recovery.
This unconventional policy has played a key role in keeping yields depressed relative to improving economic data. We expect this environment to continue for some time. To ensure a sustainable recovery amid growing government debt issuance, central banks will likely seek to restrain gains in yields.
Our portfolio position
While bond yields are making all-time lows around the world, credit spreads ended July near four-month lows. Investment grade corporates have been a key beneficiary of central bank support in this crisis, with their outperformance now having pushed spreads back to their long-term averages. While this deterioration in valuations is a factor in our decision making, we have seen some stabilisation in fundamentals, while technical factors – including central bank support – remain supportive. Within the credit opportunity set we are cautious on global high yield, where lower quality credit remains vulnerable to repricing and has the potential to underperform in line with previous recessionary episodes. Valuations do not reflect the deterioration in fundamentals (higher debt with a large shock to earnings) and higher default risk inherent in this asset class.
Throughout July we have continued to reduce exposure to credit sectors where we have seen strong outperformance – global investment grade credit, for example. We have also reduced exposure to Australian higher yielding credit where the outlook for the Australian banks has deteriorated and the market is underestimating the increase in non-performing loans. Our preferred credit allocation remains Australian investment grade corporates.
With credit and rates markets having performed strongly over the last four months, we have been looking to diversify exposures through some relative value opportunities. One key portfolio theme is the outperformance of Europe versus the US. While the management of the COVID-19 related lockdowns and the ensuing easing has arguably been handled well on a relative basis in Europe compared to the US, the economic policy response has been the more important development.
The European Central Bank has responded rapidly to support the wider economy and periphery bond markets. Importantly, we have also seen a significant shift on the fiscal policy side with stronger action from Germany and cooperation to develop the European Recovery Fund through jointly issued debt in the region. The implementation of this theme is reflected in two positions: short US high yield credit versus long European high yield credit; and long Italian periphery bonds, with Italy set to be a key beneficiary of the European Recovery Fund, alleviating fears over funding for member states.
In rates, we are expecting a prolonged phase of low and stable yields, with limited scope for a big directional move in developed market sovereign bonds, as central banks continue to dampen volatility. The reward for taking active duration risk is expected to remain low. We continue to focus our duration longs in Australia and the US, where shadow cash rates argue for lower policy rates versus Europe and the UK, where we maintain some short duration positions. We have also seen a loss of economic momentum in both Australia and the US which supports the need for further monetary and fiscal stimulus. With recent central bank meetings behind us, we think the focus is likely to shift back towards fiscal stimulus and government debt supply, which could weigh on yields over the coming months.
It remains an uncertain environment; however, we are confident the portfolio is well positioned to deliver superior reward without excessive risk. Our focus remains on positioning the portfolio for quality income generation across a broad opportunity set, keeping well diversified and remaining flexible to both capture opportunities and manage risk.
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