Expectations minus reality equal disappointment

In the second half of last year many investors had concerns over the defensive portion of their portfolios as the US reflation story re-priced bond yields higher and bonds posted modest negative returns. Today, the bond market sure isn’t acting like it’s worried about the Federal Reserve raising interest rates for the third time in six months. Fixed income assets have been rallying and have delivered positive returns for the fifth straight month. The Bloomberg Composite Bond Index gained 1.17% for the month of May and 3.18% year to date. In comparison the Australian equity market delivered a return of -2.75% for the month of May and 2.98% year to date – not much different to the return on Australian bonds for the year.

One reason why the bond market is so sanguine is that while the labour market is strong, inflation is slipping back below the Fed’s 2% target. Beyond the inflation numbers, there are some doubts about the economic rebound in the second half of this year, with the Trump administration’s pro-growth, fiscal stimulus agenda that focused on tax reform and infrastructure spending delayed at best. Expectations minus reality equal disappointment. The economic picture does not present a particularly threatening bond bear case, as it looks very much the same as every year since the Great Recession: weak first quarters have become the norm, followed by significant rebounds in the second and third quarters. Most of the soft data (sentiment and confidence indicators) point to 3% growth for the second half of the year. Following a weak start to the year, that would leave the yearly pace right on the 2% that has defined growth in recent years.

Moving to our current outlook and portfolio positioning, our view remains that duration risk is expensive, though clearly less so than the middle half of last year. With yields now close to the lows for the year, return expectations remain modest with US and Australian bonds expected to deliver around 1% over the next 3 years. As the US moves forward on the policy tightening agenda, US bonds are at least starting to offer better relative value versus those of other key regions, notably Europe. It may seem ridiculous to a casual observer that a US 10 year note yielding 2.20% would be viewed as a high-yielding instrument, but when compared with the 0.30% offered on German 10 year bunds, it makes more sense. We have started to add duration back to those higher yielding countries notably the US and Australia and moving shorter in the lower yielding countries in Europe where valuations are most expensive. We continue to run lower and more diversified duration risk than the benchmark, with a small relative short duration position in Australia, a reduced outright short position in US Treasuries, and the largest short now held in German Bunds. More broadly we remain better positioned should yields move higher, curves steepen and inflation expectations move higher.

The performance of riskier assets has been supported for some time by the Goldilocks regime of healthy growth and stable inflation. Credit does not require a booming economy, but obviously doesn’t like a recession; it prefers slow steady growth. Regimes do not last forever but the longer one lasts the more investors assume it will last forever, inducing less caution and more leverage. We prefer to be more cautious in these environments – as valuations move further into expensive territory, risk becomes very asymmetric. We are now approaching this asymmetric point where there is little compensation for defaults and recovery on investment grade credit assets. With spreads now close to pre-GFC lows, return expectations are modest with US and Australian investment grade credit expected to deliver around 2-3% over the next 3 years.

Our credit exposures are modest with a bias towards shorter dated credit in Australia over longer dated credit in the US and Europe. Credit curves globally have flattened which means we are not getting compensated for taking credit or term risk in longer dated assets. There is now far less dispersion among corporate sectors, by industry or by credit quality, than we have seen in recent years. Coming at a time of high corporate leverage, and with central bank liquidity growth starting to roll over, we also have a preference towards higher quality assets. We still see value in residential mortgages but are mindful of the liquidity premium and recent softening we are seeing in the Australian housing market. Government related sectors (semi government and supranational) still remain on the expensive side of valuations. We have continued to reduce exposure to these sectors given the deteriorating fiscal outlook for the semi governments and have reallocated some of this capital into higher quality covered bonds as a replacement AAA asset at more attractive valuations.

Our focus remains one of protecting capital and delivering positive absolute returns. This leaves us defensively positioned with elevated cash levels, less interest rate risk than the benchmark and modest credit exposure. We are awaiting market volatility and a repricing of asset classes to invest more constructively.