Commentary: Climb the wall of worry

I’ve found myself checking the overnight movement in bond yields each morning when I wake up. I used to check the performance of equities first thing, but now that feels so passé. With the US long bond moving up or down 1-2% a day, why bother following the paltry 0.5-1% moves of the S&P? The continued repricing of bonds has been vicious. The US 10-year bond yield has moved from around 3.5% in the middle of the year to breaching 5% intra-month, the highest level since late 2007. The US 2s10s curve (the difference US 10-year yield and 2-year yield) bear flattened from being inverted over 100bps in the middle of year to now being only 20bps away from each other. The market has definitely dropped the idea of a soft landing and moved solidly into the higher for longer camp. For us, this is a positive, as it means the market is now being more realistic about the outlook for rates. While it is still too early to signal the all clear, rates appear to be settling at this new level, potentially hinting to a reduction in bond volatility over the coming months.

Fundamentals improving

The US economy is holding up better than expected. US PMIs continue to improve, with services rebounding and manufacturing recovering. Our recession model, which hit its highest reading since 1990 back at the beginning of the year, is now close to switching off, with all the short term indicators of an imminent recession gone. The conundrum of this rate hike cycle is that consumers and corporates are heading into it with relatively healthy balance sheets, limiting the effect of tightening. The US consumer continues to enjoy real wage growth and recent revisions also suggest US consumers still have $800bn in excess savings, which at the current drawdown rate assumes 3.7% of GDP could be spent over the next 15 months. This helped contribute to the US retail sales beat this month and can provide a safety net for consumers if job losses increase. The majority of homeowners were also able to lock in 30-year mortgage rates between 3-4%, well below the current 7%+ for new loans. While credit card and auto loan delinquency rates are ticking up, they have merely returned to the pre-COVID low after being artificially depressed during the pandemic. So far, the consumer does not appear to be cracking.

Chart 1: The US consumer still has capacity to spend

The recent uptick in the participation rate suggests that the labour supply is recovering, reducing pressure on wage growth while keeping unemployment anchored. The fall in sales looks to be stabilising, which is being supported by a rebound in PPI finished goods, and with wage growth subsiding, the pressure on margins is moderating. The current US earnings season continues to beat expectations and so far show no signs of the US economy rolling over. So far, 79% of companies have beaten expectations with an earnings surprise of over 7.4%. Equity market weakness has been from analysts readjusting future expectations and the move higher in bond yields, as opposed to any sign aggregate demand is falling.

Upgrading equities and high yield to neutral

After falling more than 10%, equities are looking more attractive to us. While the US equity market is far from cheap, S&P 500 forward P/Es a year out look more reasonable. While analyst expectations for future earnings have been lofty, our macro driven earnings models have caught up to expectations. Equity positioning is no longer stretched, sentiment is bearish and the market appears oversold. For these reasons we have upgraded equities to neutral.

Chart 2: EPS expectations in line with our macro models

Corporates are seeing an increase in interest expense but interest cover remains healthy, thanks to relatively stable earnings. With the upgraded view on the US economy and earnings, we have similarly upgraded high yield (HY) to neutral. Spreads have pushed wider and sovereign bond yields have risen, making the overall yield attractive at over 9% in AUD terms. Given the high starting point, high yield’s all- in yield has to move 2.5% higher to lose money over 12 months, ignoring defaults. Spreads on high yield bonds are still relatively neutral between the 50th and 60th percentile in the US and EU. However, credit default swaps (CDS) spreads have widened substantially, with the US HY CDX at the 94th percentile and EU iTraxx crossover at the 83^rd percentile. We have therefore added to high yield via derivatives, using CDS rather than buying HY cash bonds.

Some may ask why we’re not more positive. Strength in the US economy may cause investors to question how high sovereign bond yields need to go. We believe bond volatility will likely continue to put pressure on equity multiples and spreads. It is too soon to sound the all clear, given the amount and pace of monetary tightening. The rest of the world is slowing despite US resilience and geopolitical tensions being on the rise. Further signs of inflation moderating, more dovish central banks, improving economic activity outside of the US and a détente in hostilities would help improve our view. The market’s recent negative momentum may continue, so for now, we recommend thinking about protecting any addition to equities via put options, which still remain historically cheap. However, we believe the market will start to climb the wall of worry over the next few months.

Remaining neutral in duration but playing the curve

The US bared the brunt of the recent bond sell off, rising over 100bps in the past three months. Australia fared slightly better with 10-year yields rising over 80bps and Europe was the relative safe haven with German 10-year yields only moving 40bps. The front end of the US curve only rose by less than 30bps over the past three months, providing relative stability. US real yields have also increased 100bps from 1.5% to 2.5% over the past three months, which is starting to look attractive.

The market continues to grapple with the strength of the US economy and the gargantuan issuance expected from the US treasury. This is occurring at the same time that the US Federal Reserve continues to push forward with quantitative tightening and foreign central banks are no longer required to hold as much US paper. We believe this volatility will continue as the market tries to determine where fair value is for the long end of sovereign curves. However, one silver lining has been the surprise uptick in corporate income taxes collected by the government, which has reduced the funding need in November, causing treasury issuance to come in lower than expected. Our models suggest US and Australian 10-year bond yields are currently appropriate based on real GDP growth, inflation and policy rates, but these are all in flux. In the meantime we favour the front end of the US curve and inflation-linked over nominal in the US, while also favouring markets outside the US like Germany and Australia, where we believe growth is more likely to roll over.

Portfolio positioning shifts

We added to both equities and high yield over the month to reflect our change in view. In equities, we took profits on half of our puts and added to US equities via futures. This increased our delta adjusted US equity position by 5%, bringing our total equity exposure to just over 22%, up from 17% last month. We also increased our allocation to high yield by 2% from zero by removing half of our US high yield CDS protection. We continue to hold a high allocation to credit, mostly in investment grade, to add carry to the portfolio. This is supplemented with our allocations in Australian private debt, securitised credit and insurance linked securities, which continue to offer attractive all in yields.

In duration, we reduced some of our exposure in the front end in favour of the back end of sovereign curves, to take some partial profit on the recent bear flattening. This was primarily done via selling 0.5 years in Australian 3-years which we believed were mispriced, helping insulate us from the sell-off after the higher than expected inflation Australian print. We increased our allocation to German 5-year Bunds and removed our short in UK Gilts. We added 5% or 0.2 years of duration to US 5-year inflation linked bonds (ILBs), which offer real yields of 2.5%. Our net duration exposure increased from 2.3 years to 2.5 years at the fund level.

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