Commentary: All eyes remain on the central banks as conditions tighten
As growth fades and inflation continues to threaten, 2022 has gotten off to a bumpy start. In this environment we have positioned the portfolio more conservatively by reducing credit risk and we have maintained our interest rate exposure at a low level.
As we begin 2022, markets continue to focus on the outlook around inflation and growth and importantly, the reaction function of central banks. Growth appears to have peaked from elevated levels and whilst slowing, we expect growth to remain above trend. Inflation is expected to peak in the first half of this year, but the question remains; will it stay above the central bank targets? What is clear is that monetary policy settings remain extremely accommodative and will need to be adjusted. The question is when and by how much. The uncertainty around the timing, the pace and the number of official rate increases is feeding significant volatility in markets. Rising bond yields, wider credit spreads, and weakness in equity markets signal a challenging year ahead. We expect more volatility is in front of us.
The disparity between central banks and the markets can be seen in the difference between what central banks are signalling and what rates markets are pricing into yield curves. For example, the RBA has ended its quantitative easing programme as expected and has continued to explicitly state that this does not signal that official rate increases are imminent. It will be patient and be guided by the data and while the end of 2022 is a possible start, their guidance is for an expected start in 2023. The market is not so sure about this timing. It is currently pricing in four rate hikes by the end of this year.
‘Just right’ will be challenging
Is the market or the RBA right? Well, it’s too early to know given the outlook is uncertain and is subject to change. Does growth continue to fade? Does inflation subside or does a tight labour market feed into pressure on wages, which then forces the hand of policy makers? Does geopolitics come into play? Either way a policy mistake is always a risk for any central bank. Tighten too early and too much and push the economy into recession. Leave it too late and central banks get behind the curve and must become more aggressive to kill inflation, which derails markets. A ‘Goldilocks’ scenario of moderating growth, fading inflation and moderate rate increases that don’t derail risk assets is possible, but we would say unlikely.
Against this backdrop, it’s not surprising that January has been a bumpy start to the year. Markets are never happy when financial conditions tighten. Bond yields have been moving higher and pricing in expected changes to policy setting. Duration based assets are clearly under pressure as we move through this transition phase. Equity markets moved lower, arguably off the back of the expected increases in the discount rate and concerns on liquidity withdrawal. Credit markets, however, have been relatively well behaved and while spreads have drifted wider, they have not sold off aggressively. US high yield is interesting, as spreads have been more subdued than expected in this type of environment. One possibility is the continued search for higher income with the yield on high yield now closer to 5%. It could also reflect that while higher rates will impact long duration assets, the current expectations of Fed rate hikes will not meaningfully impact the default risk of even the riskiest companies.
Shoring up against uncertainty, for now
So how are we positioning against the current backdrop? The portfolio’s objective is to provide investors with a defensive income solution that manages downside risk. In this environment it pays to have very little interest risk and our duration exposure has been maintained at very low levels for some time now. It is also prudent to improve the average credit quality of the portfolio.
Last quarter, we reduced overall credit risk and adjusted the mix of credit exposures. Global high yield is now 2% from a high of 5%, as valuations moved to very expensive levels in the December quarter. Emerging market sovereign debt exposure was reduced, based on the view that a stronger USD combined with challenges around lower vaccination rates in the developing world would be negative for those markets. Increases to USD denominated Asian credit via our SISF Asian Credit Opportunities Fund reflected the valuation support in this asset sector with the risks, particularly around the Chinese property, reflected in a very high-risk premium. US securitised credit exposure remains unchanged and should continue to benefit from a stronger US consumer. This, combined with the fact that it’s a floating rate asset class, means it should benefit from the current environment. Domestic hybrid securities also continue to offer a reasonable yield via a subordination risk premium. We have added a 2% exposure to the Schroder Real Estate Debt Fund, which provides exposure to commercial mortgages. With a yield over 6% and the loans being relatively short maturity and secured by collateral, it provides an attractive opportunity.
We continue to hold low levels of outright duration, given the views around bond valuations and the risk of more hawkish central banks. We have 0.25 years of duration, reflecting the view that the adjustment in interest rate expectations means duration-based assets are likely to continue to be volatile, hence we are looking to insulate the portfolio from expected increases in bond yields. We have cross market positions in which we are long Australia against a short US treasury position. We believe the risks around inflation are larger in the US and the likelihood that the US Federal Reserve will be forced to act. In the US we also have a yield curve flattening position, where we are short the front end of the yield curve against longer dated maturities, as we expect more pressure and adjustments to shorter-dated interest rates. The small long duration position in Australia reflects the view that the inflation situation is more contained than in the US and the RBA’s reaction function will be more gradual. It also provides some downside protection if risk assets come under pressure.
In terms of currency exposures, we have a long USD and long JPY position, as we expect these defensive currencies will continue to provide an effective downside risk hedge if equity and credit markets continue to be pressured. Cash levels are elevated, reflecting the desire for liquidity in the portfolio and from the recent reduction in credit exposure. We currently prefer cash over sovereign bonds, even at the low cash rates, given the desire to protect capital and the prospect of continued negative returns from sovereign bonds. We remain defensive and are looking to position the portfolio more constructively as we move through this adjustment phase in market.
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