Commentary: The ongoing tempest of 2022
2022 has seen a lot. It’s seen the worst bond market performance since the 1980s, the biggest commodity outperformance since the 1960s and large moves within and between equity markets. It has seen a terrible conflict in Europe, a COVID crisis in China, and the first 50bps hike by the Federal Reserve in 22 years, and its only June. This confluence of factors has caused some pain and apprehension in the market, but they can also be a cause for optimism.
Late cycle dynamics
The tempest has three drivers, all of which are ongoing. First, enormous fiscal stimulus drove above-trend growth that is now moderating. Second, developed market central banks have made an intentional decision to err on the side of caution and keep monetary policy easy, even as growth rebounded. The training wheels are off as policy tightening races to catch up. Third, events in Ukraine and China are creating a negative supply shock and more global inflation for a given level of growth.
We continue to approach these dynamics through a ‘late cycle’ lens. A late cycle phase is typically defined by a slowdown in growth, low levels of unemployment, rising inflation, higher cash rates and a flattening yield curve. While it is early for a ‘late cycle’ environment, given that the recession was just two years ago, we believe that this cycle could be accelerated.
Inflation has been the economic story this year, with US CPI hitting its highest year-on-year level since 1980. What’s notable, however, is how these inflation numbers change going forward. US inflation has likely peaked but will not return to 2% quickly. Critical CPI components show signs of peaking – used car prices, wages and housing. Another change is that more is priced into markets. Expectations of US, European and Australian central bank policy has seen one of the fastest hawkish shifts in the last 40 years. The yield on the Australian 10-year government bond has risen 180bps year-to-date (to 3.50%). These are significant shifts.
A necessary growth slowdown
Most of the impact of changes in policy rates occurs indirectly via changes in broader financial conditions. This includes longer-term interest rates, credit spreads, exchange rates and equity prices. It is important to monitor how different financial variables – not just the policy rate – affect the real economy. Risks to the global growth outlook skew to the downside already and as monetary policy tightens (alongside financial conditions, which have already begun to tighten meaningfully) downside risks to growth, and eventually inflation, will increase further. Tighter financial conditions mean slower growth and the tightening reflects what’s priced into markets to restore balance to the labour market and cool the economy. The recent tightening in financial conditions will persist in part because we think the Fed will deliver on what is priced.
We expect bond yields to move higher as the focus remains on above-target inflation that keeps central banks marching higher towards a more neutral policy stance. However, the necessary growth slowdown will produce conditions which traditionally favour government bonds over the medium term. To get more constructive on the outlook for government bonds, we are looking for:
- a peak in inflation;
- peak Fed hawkishness in bond markets; and
- whether US economic data starts to confirm a more concerning slowdown.
Risky assets remain vulnerable
Credit markets have moved away from familiar waters in recent months and investors have been forced to position for some volatility. Persistent spread widening early in a hiking cycle is not normal, and neither is credit’s lagged reaction to elevated rates and equity volatility. These abnormal correlations reflect the tension between elevated macro concerns on the one hand and the still healthy corporate credit fundamentals on the other.
Looking ahead, we believe that macro stress points are pivoting from rates and inflation risk to growth and credit risk. We therefore expect continued spread widening. Our current thinking is that inflation pressures have forced central banks into an extremely front-loaded hiking path – this is now an accepted fact. Another (albeit less widely accepted) fact is that these hikes will increasingly come at the expense of slowing growth.
The magnitude of slowdown, soft landing versus hard landing, will continue to be debated, but the forced compromise facing central banks on economic growth is clear. We then ask ourselves – are credit markets pricing in growth fears? We remain wary that a more adverse recession/stagflation outcome for the economy will inflict more damage on the credit asset class later this year – hence our expectation of continued weakness in developed market credit spreads.
We have moved up in quality, favouring investment grade over high yield in both Australia and the US. Slowing growth and tighter financial conditions should weigh on the performance of lower quality credit. Our focus is on playing it safe, remaining patient and defensive as slowing growth and ongoing tightening are meeting an improved valuation picture across both government and credit assets.
We are maintaining a neutral stance on government bond duration overall and continue to hold a cautious position across corporate credit.
Our key interest rate positions include:
- modest short duration positions in the US and Europe, as we expect yields to continue to rise, driven by inflation pressure and central bank tightening vs long duration in both Australia and the UK (given what’s priced into markets and the likelihood this is not delivered by the RBA and BOE);
- small exposure to yield curve flattening, albeit we have moderated these positions given further repricing higher in yield is likely to be seen across the yield curve; and
- a long position in Australian inflation-linked bonds, as we believe Australian inflation is catching up to that in the rest of the world, and this risk is under-priced.
Together these should help to insulate the portfolio from further increases in bond yields. Although we expect that the bulk of the interest rate repricing has now probably occurred, we expect yields to continue to rise as rate hikes are delivered and uncertainty about inflation persistence is high. We are looking for an opportunity to allocate more constructively to government bonds and position for the eventual peak in policy rates and the global growth slowdown.
Our key credit exposures are:
- a 20% exposure to Australian investment grade credit, a high quality, low volatility asset class, which has already underperformed global investment grade peers;
- short positions in US investment grade and US high yield, which are potentially vulnerable to Fed tightening and balance sheet reduction;
- small long positions in emerging market local rates, and Asian corporates, which each offer considerable value, despite some cycle headwinds; and
- small exposures to Australian higher yielding corporates, mortgages and commercial loans.
The uncertain macro environment alongside the removal of central bank liquidity and potential recession risk keeps us defensively positioned with a low credit allocation. Earlier this year we have progressively reduced our exposures to risky, lower quality credit. We favour investment grade over high yield credit and are looking for opportunities to reinvest as valuations continue to improve across the credit asset class.
As the year progresses, we should see a better balance between inflation and growth where a lot of the bond and credit underperformance should be behind us. While we expect to move the portfolio to more constructive positioning later this year, we remain cautious for now. Patience is required as we navigate this challenging fixed income environment.
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