Bonds remain vulnerable despite recent falls

The inauguration of US President Donald Trump was the defining feature of January for bond markets. After the large sell-off in bond markets in the fourth quarter, there was a rally in global bond yields in the first half of January, only for this to retrace in the second half of the month. US Treasury yields were close to unchanged over the month. Australian bonds slightly outperformed the global move, thanks in part to a weaker CPI reading and the contractionary effects of the higher currency. Europe was the underperformer as German yields rose in January. The rise in the European headline inflation rate, coupled with a strengthening of GDP growth had the market looking for the European Central Bank to begin to normalise monetary policy. Risk assets, including credit, have continued the positive momentum from 2016 into January.

Over the month, the Portfolio returned 0.69% (before fees), taking the 12-month return to 3.00% (before fees), which puts us ahead of the benchmark by 70 basis points over one year. Against the benchmark, our short duration positioning, an exposure to yield-curve steepening, and our inflation-linked exposure added value. Through the month, we held steady our aggregate duration position and partially trimmed our steepening position in the US, given the sell-off in the long end. Credit exposures were held roughly unchanged at close to benchmark levels.

Wary moves

Financial markets have continued to embrace the reflation thematic. A very different story from what was unfolding at the start of 2016 where most investors were focused on deflation, continued central-bank accommodation and the movement of rates into negative territory. Markets are now focused on US political developments and the potential impact of inflationary pressure brought about with the Trump presidency and the run of stronger economic data in the US and Europe.

For most of January, movements in bond yields were relatively benign after Trump’s inauguration, despite the number of market headlines and ‘Trump tweets’. The market still seems to be coming to terms with Trump with a wait-and-see approach. The Federal Reserve is also in wait-and-see mode until it gets more clarity on the size, composition and timing of the fiscal stimulus being planned by the Trump administration. It will be some time before it becomes clear whether or not both Houses of Congress support the fiscal plan. Until that time, the Fed is unlikely to commit itself to a more aggressive pace of interest-rate hikes, particularly when inflation is still running slightly below its 2% target.

While we have seen a 1% move up in bond yields, bond valuations still remain structurally expensive, albeit less so compared with their lows of 2016. The US will face fiscal easing in an economy at, or above, full employment, which is likely to be associated with a boost to economic growth but also inflation and ultimately higher interest rates. This suggests bonds still remain vulnerable. Accordingly, we have broadly held our interest-rate positions steady through January. Head-level duration remains at one year short, diversified across markets – the US where we see the most cyclical upside, Germany where valuations remain the most expensive and Australia where the cycle is potentially at a turning point in addition to valuations being expensive. As curves have steepened, we have taken the opportunity to reduce some steepening exposure in the portfolio as longer-dated bonds (especially in the US) now look better value. We hold exposure to inflation-linked bonds in the US and Australia where we believe an uplift in inflation looks to be under-priced.

Credit markets have enjoyed solid performance over the past several months driven by the improvements in economic growth and earnings. Valuations of credit assets are now on the expensive side of fair value, which keeps us cautiously positioned. We are modestly overweight credit with the exposure focused in Australian assets of short-dated, high-quality corporate issuers. With no major inflation hiccups likely in the near term to force the major central banks to shift rapidly to a more hawkish stance, and with equity and credit markets remaining supported by accelerating earnings growth, the current ‘sweet spot’ for risk can continue. We believe this ‘sweet spot’ is fully priced in markets with little to no room for further capital appreciation. The risk in credit is very asymmetric, which leaves us close to a neutral position and waiting for wider spreads to invest back into the sector.

Cash levels remain reasonably elevated, albeit we have reduced cash to fund our investment in inflation-linked bonds in recent months. We remain defensively positioned, mindful of preserving capital, evident through our interest-rate and credit positioning, and we’re looking for opportunities to reinvest as markets adjust.