The markets’ euphoria over President Trump faded through the first half of the year, as political reality set in. Trump may be looking to ‘drain the swamp’ but for now his presidency is stuck in a quagmire of policy delay, bureaucratic instability, impeachment threats and a hostile media, leaving his signature economic policies of tax reform and infrastructure building delayed at best. While acceptance of this reality saw many market participants pare or close ‘reflation trades’ – seeing bonds rally, inflation expectations fall and the USD weaken – for the most part the cyclical improvement of the global economy continued nonetheless. Equities and credit seemed to take their cue from the latter, plus ongoing central bank accommodation, to continue to rally.
For markets, it was therefore a rotation from reflation back to carry in an environment of benign macro outcomes that was the main thematic. However, this narrative misses what was perhaps the main development – which was the signalling by central banks that we are close to ‘peak accommodation’.
The Fed tightened steadily, in spite of softer than expected short-term US data. This was a notable departure from the Fed’s actions since the GFC. Two explanations are possible: 1) with the labour market close to full employment, the Fed, still believing in the Phillips curve, views the inflation lull as only temporary, and 2) worried about financial stability, the Fed believes it needs to get rates higher before the next downturn, and so is taking advantage of favourable financial conditions to move towards neutral. Most likely the Fed’s actions are a combination of these two things – ongoing progress against its usual macroeconomic targets, and a greater recognition that central banks have overstayed their welcome in markets.
Other central bankers are following the Fed’s cue. In Europe, with economic conditions improving, and distortions due to central bank buying having run to an almost terminal point (the ECB has nearly run out of Bunds to buy), ECB President Draghi is signalling cautious retreat. In turn, the shift by the larger central banks allows smaller ones to follow - the Banks of Canada and England have in the last several weeks embraced a hawkish tone. Central bank balance sheets appear close to peaking.
Reduced future involvement by central banks in markets should deliver some return to ‘normality’ – both as markets realign with longer term macroeconomic fundamentals, and as higher volatility and lower correlation discourages momentum/carry trades and generates more differentiated asset outcomes. This would be an environment more conducive to our style.
While hopeful of change in the market environment, we also need to be realistic. In spite of what’s written above, central bank involvement is likely to be a key feature of markets for years to come, so even if central bank intervention is not a permanent state, we must recognise its persistence. An example in our process of this recognition is the way we enhanced our bond valuation model about a year ago, to capture the likelihood that cash rates stay much lower for longer than normal cyclical rules would imply.
Early in the year we took partial profit on some of our reflation trades – including short duration and long inflation positioning in the US, and yield curve steepening exposure – and have refocused the portfolio back on value. This means staying short duration relative to benchmark, and holding a very modest credit position – as both interest rate and credit risk is expensive.
Within these two main dimensions we also have our value bias reflected. Our short duration position (currently totalling 0.7 years) is concentrated in Europe, where valuations – reflecting ECB intervention - are most extreme. While all developed bond markets remain expensive on our measures, in general our preference is to be short the low yielding / most expensive markets in favour of owning the higher yielding / less expensive markets. The underperformance of US rates over the last several years has put the US back into the ‘higher yielding’ camp alongside Australia, and we view opportunities between these two markets from here as being mostly tactical (currently favouring Australia over the US). We’re still biased for some yield curve steepening with term premia remaining depressed, and added to this positioning recently. We also retain a small long position in inflation-linked bonds mainly in Australia, as pricing for future inflation protection remains cheap.
In credit we’ve made few changes to our broad positioning over recent months, having steadily pared exposures over the prior year as spreads compressed. We hold a very modest absolute exposure, about the benchmark weight. Our preference remains for short duration high quality Australian debt over longer and lower quality global exposures, and over subordinated domestic issues. We’ve also recently pared our government-related spread exposure to semi-government and supranational issuers to below benchmark weight. Cash remains elevated as a result of our negative valuation view on both government and corporate opportunities.
This cautious positioning of the portfolio is a function of the lack of opportunities the current market environment presents. Vis-à-vis the benchmark, this positioning represents a material change to a few years ago. In 2012, our very constructive positioning with respect to credit contrasted greatly with the undiversified benchmark portfolio, whereas now our portfolio is defensive against (what we see as) a risky benchmark. As outlined, we believe some seeds are now in place for restoration of a more normal market environment, and are remaining patient and true to process in the meantime.
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