Through the first six months of the year, several themes have been playing out. The US economy has powered on and the Fed has steadily tightened. Other economies are also seeing solid growth but their lagged cyclical position (generally still with spare capacity) means tightening elsewhere is delayed, and at the margin, data has softened. While US rates have underperformed, US equities and credit have outperformed versus other markets, as US corporate profitability looks to be tax-fuelled over the next 12 months.
The renewed rally in the USD and higher US yields is creating concern for emerging markets but the situation appears more stable than in 2015 when commodities were plummeting and China faced a capital flight crisis – indeed, oil has rallied, partly due to politics. Inflation is lifting but not yet accelerating worryingly.
2018 to date has been a choppy experience for investors compared to the smooth sailing of 2017, as markets grapple with the retreat of USD liquidity as the Fed tightens, the transition to a less friendly growth-inflation mix as output gaps close, and the prospect of a more general withdrawal of central bank accommodation. The recent rise of trade protectionism – likely to be inflationary, and likely to hurt growth elsewhere more so than in the US – only adds to the story. Volatility is higher, and risk appetite has stalled, though not yet retreated.
We are reasonably upbeat on the economic outlook but are cautious on markets given the starting point of generally compressed risk premiums.
The US economy remains solid. Unemployment has finally moved down through 4%, and growth back up to 3% as Trump’s tax cuts kick in. Much has been made of the flattening of the yield curve as a recession warning signal, however our detailed recession modelling is indicating US recession is still 18-24 months away. The hangover could well be worse due to the magnitude of fiscal largesse at this stage of the cycle … but that is an issue for later. This leaves the Fed at the sharp end of the policy tightening spectrum with (amazingly) a neutral cash rate setting in its sights after so long well below. 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 a tighter policy position would likely be difficult for markets.
Markets are currently making a deal of economic divergence. It’s true that the US cycle is further advanced than elsewhere, and China has slowed over the past six months. The latter has impacted China’s trading partners, including Europe. Were this downturn more prolonged, it would be more serious, especially as it could help to underpin USD dominance and hence further undermine emerging markets. However, while cautiously monitoring developments, we don’t think there’s reason to become more concerned about the non-US growth trajectory just yet. It does seem clear however that policymakers outside the US – including in Australia – are in little hurry to hike.
Bond valuations remain overwhelmingly expensive, though as bonds – especially in the US — have to a degree already repriced but expensive riskier assets have not, fixed income is starting to look appealing. Our judgement, however, is that it’s still too early to add back much duration with the cyclical risks to the upside. Portfolio duration relative to benchmark stands at one 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 1.70yrs 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.
Credit risk, meanwhile, is priced for a healthy economy, but not for liquidity or policy withdrawal. 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. Our credit exposure is modest in absolute terms and only slightly overweight relative to the benchmark. 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 weather higher yields and greater volatility, and to capitalise on the opportunities created.
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