Commentary: This cycle has a different dynamic
This time around, inflation is likely to be falling over the slowdown phase, which is a very different dynamic compared to previous cycles. The easing of inflation could mean a less challenged landscape for risky assets and a more positive environment for government bonds.
Economies have been stronger than we expected. Our investment strategy has been based on the assumption that strong developed market growth was set to slow sharply as post-COVID stimulus waned and policy tightened at the fastest pace in 40 years. That was the message from both a variety of leading indicators, as well as our US recessionary dashboard. A sharp slowing, from an elevated base, has often rewarded defensive positioning, a pattern we thought would unfold again. But this cyclical regime is different - in a high inflation environment, it is taking longer for disorderly feedback loops to kick in, because economic decisions are typically motivated by nominal values.
It is on the inflation front that we have seen the most encouraging macro development this month, with annual growth in inflation decelerating and printing below expectations. Even in Australia, (which has lagged the global acceleration in inflation) annual growth in the RBA’s favoured trimmed mean measure also undershot expectations, suggesting Australian policymakers will feel increasingly confident that a sustained disinflationary pulse has established itself. The weaker starting point for inflation is also consistent with inflation returning to target slightly earlier, lessening the probability that the RBA will need to hike as aggressively from here.
Government bonds still looked primed for a comeback
The possibility that central bank rate hikes to date weigh on economic activity into year-end, and that we expect we are getting very close to the end of this policy tightening cycle, increases the attractiveness of government bonds, in our view. While they have been battered and bruised, we believe government bonds still look primed for a comeback this year.
Of course, in the best environments for government bonds, central banks ease monetary policy, an environment we see taking shape over the next year. Most bond markets are already pricing the peak in central bank policy rates. We continue to see a moderation in economic activity and inflation where such a deceleration, even if associated with a soft landing, could see central bankers adjust their hawkish stances.
At the same time, we think government bonds could perform even better than average, considering the risks that markets are not pricing in. Recent moves in bond markets suggest that investors have warmed to the idea that monetary policy lags are longer now than in the years past, despite policymakers’ uncertainty about their timing and effect. The risk to this increasingly popular view, naturally, is that lags have not lengthened and this time is not different after all.
Recessionary risks and asset implications
Recession risks remain on high alert based on yield curves. The recession probability based on the US 10-year vs. 3-month yield curve has remained the highest at around 67%, while other US curves are pointing to around 50% recession probability. But equity and credit markets are not pricing in any recession risk based on spread levels and the equity risk premium, as well as total returns. That said, the recession probability based on our macro indicator, which has had a better track record in signalling past recessions, has stayed elevated.
There has been a decline in the number of variables signalling recession on our dashboard, which has fallen to 50% (previously peaking at 70% only a few months ago). Overall, and according to our dashboard, there is little sign of an imminent recession as nearly all the variables with a short recession lead time (indicators in the near-term macro and financial markets category) are not signalling recession.
In terms of asset implications, slowdown phases have typically been negative periods for risky assets. Besides the weaker growth backdrop, headline and core inflation have tended to rise during slowdown periods. But this time around, inflation is likely to be falling over the slowdown phase, which is a very different dynamic compared to previous cycles. Despite the slowdown in economic activity, the easing of inflation could mean a less challenged landscape for risky assets if the slowdown is not followed by a recession.
As we start to position for the end of the cycle, we believe asset allocators should consider rebalancing back in favour of fixed income. We believe high-quality fixed income now offers attractive income levels and improved diversification benefits, given the restoring of fixed income valuations. Our key portfolio positioning around these themes include:
- A bias to high quality issuers within our credit allocations; we continue to position for an economic slowdown with an increased weight to high quality investment grade issuers and sectors, including utilities, telcos and universities. We have been avoiding sectors like AREITs that have been under significant pressure due to concerns over asset valuations, particularly in the office sector, given the rise in interest rates. We also see good value in short-dated subordinated debt in high quality names like QBE and Westpac. This exposure enables access to attractive yield while minimising exposure to riskier credit
- Owning interest rate risk and government bonds in the countries where central banks have tightened most aggressively / where inflation is showing best evidence of softening (e.g. the US) and in markets which have greater sensitivity to interest rates (e.g. Australia). Within these markets, short-dated government bonds should do relatively better than longer dated, once interest rates peak.
- Staying liquid, providing greater flexibility to position actively. We expect market volatility to remain high as we come to the turn in the cycle. We expect to use this volatility to continue to accumulate interest rate duration and spread assets at attractive levels.
Learn more about the Schroder Fixed Income Fund.
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