Commentary: Are we there yet?

Thus far, 2022 has been one of the toughest years for financial markets in decades, with bonds and equities declining in unison. The September quarter was very volatile, with July generating strong returns across most asset classes, followed by weakness in August and September. Interest rate volatility reached new cycle highs with global bond yields moving higher and risk sentiment deteriorating, reflected in weaker equity markets and wider credit spreads. The moves came as investors grew increasingly concerned about a recession, thanks to a combination of hawkish central banks, major disruptions to Europe’s energy supply, and some serious market turmoil in late-September that was connected with the UK government’s fiscal policy. While global bond yields moved higher over August and September, Australian bond yields haven’t breached the highs from mid-June, driving outperformance of the Australian bond market for the September quarter relative to its global peers.

Key cyclical views:

With the magnitude of drawdowns this year, a legitimate question to ask is whether the worst is behind us? A huge restoration of value across fixed income markets has now presented some great opportunities, even though macro volatility is high. The  drivers for a more significant process of normalisation of volatility from here are:

• A convincing confirmation of a downward trajectory on inflation, stronger than the type of evidence we have seen recently and that has led to a couple of false starts on the pricing of peak inflation. This is more likely to happen as negative base effects start to impact significantly on inflation, particularly in Q1 2023.
• The crystallisation of the US Fed terminal cash rate view and a smaller level of uncertainty around it. In the current context, we expect to see this collapse of uncertainty only around the last couple of official rate increases of the cycle.
• A shift in the dynamic of equities and credit markets, whereby earnings expectations become a more significant driver, as higher interest rates have dominated the recent bearish dynamic for risky assets. This again likely requires a crystallisation of Fed terminal rate expectations, along with pressure from deteriorating fundamentals on earnings expectations.

While we expect these conditions to start to come together over the next quarter, we believe the process is likely to be gradual as fundamentals deteriorate. The timeline for meeting this condition is likely to be backloaded into late 2022/early 2023. As these conditions are met, this will allow the reduced correlation between government bonds and riskier assets to become more beneficial for portfolio diversification.

Strategic assessments:

It seems probable that the post-GFC economic and market environments have ended, however not as intended. The RBA and other central banks were caught flat-footed by an inflation surge and have been forced to abandon stimulatory policy well before strong growth could help reduce the debt burden resulting from COVID stimulus. It remains unclear what the next regime will be, however in our assessment:

• Economies and markets are undergoing a dramatic readjustment. Economies are adjusting to tight labour markets and energy supply disruption, while markets are adjusting to significantly tighter central bank policy. Fiscal policy also needs an overhaul; financed by monetary policy keeping rates low, and designed to sustain consumption rather than stimulate investment, it has become too short-sighted.
• Increased uncertainty about medium-term growth and inflation outcomes, impact of climate-related policies, geopolitical and demographic risks, should all result in investors demanding higher risk premia from fixed income and equity assets.
• To a degree this is priced. Our 3-year expected return forecasts on Australian bonds is indicating returns of 4% to 6% p.a.
• Bond-equity correlations are subject to a positive shift should inflation stay elevated, causing a rethink on traditional portfolio construction techniques. Some alternative asset ‘safe harbours’ may prove illusory.

Implications for markets:

• Investors are now demanding higher risk premia, given the increased uncertainty about medium term growth and inflation outcomes, and climate-related, geopolitical, and demographic risks. Psychologically, it mean adjusting to a world where the central banks are no longer as friendly and market supportive.
• Over much of the last 12 years, with inflation undershooting targets, central banks were often happy to push for easy policy when conditions looked tough. It was common to hear some variation of TINA (There Is No Alternative), the idea that one needed to be long equities and credit because cash offered so little. These tighter policy rates are now scrambling that mindset and with inflation elevated across the developed world, that dynamic has changed.
• The last 12 months of losses are now continuing to help normalise long-term returns, which for many years – even decades – have been well above their long-term trends. What makes this current period worse historically is that we are now noticing deep losses in nominal terms which, for many countries, has never previously happened over a sustained period outside of wars or defaults. This decade stands out versus all others and although it is still young, the main difference is the comparatively low starting point for yields.
• Rising yields and widening credit spreads have caused a lot of pain but with the restoring of value across most of the fixed income universe, investors can now anticipate several higher yielding, low volatility alternatives compared to some other asset classes.

Positioning:

The cyclical picture is becoming more supportive of bonds and valuations which are much more appealing than at the start of the year. The strategic value of fixed income has also improved with higher yields and a potentially more uncertain, higher volatility environment.

• With central banks currently tightening very aggressively, and as it’s too early to accurately gauge the impact of their actions on both inflation and growth, we are taking a patient approach to building aggregate duration.
• A pivot by central banks remains a way off in our view as policy makers deliver on what is priced into markets. We shortened duration in August and September to position for higher terminal rates as inflation remains sticky and labour demand tight.
• In general, we continue to expect yield curves to stay flat as rates are hiked. However, it is plausible that front end pricing is high enough for this cycle. We continue to look for opportunities to reduce the flattening exposure by closing our short duration positions in the front-end of yield curves.
• Credit faces a very uncomfortable macro mix, with downside growth and profitability risk adding to liquidity headwinds. However, spreads have moved significantly wider already, and while we believe riskier credit is still vulnerable, higher quality investment grade corporates offer good carry, especially on an all-in-yield basis. We have recently started to increase exposure to Australian investment grade corporates that are offering yields greater than 5%.
• We are being even more patient in adding to credit than to duration. We will become more constructive as recession risks are increasingly priced.

Macro volatility is likely to persist as we move into late cycle and a peak in official rates is formed. Despite the volatility we are optimistic that better fixed income returns are ahead, and that fixed income will retain strong strategic value to portfolios. Our portfolios are well placed to deliver on both, and we are carefully becoming more constructive in our portfolio settings.