Bond yields ended 2017 not far from where they started. Despite the best stretch of synchronized global growth in a decade, inflation has not worried investors and central bank monetary withdrawal has been gradual and transparent, putting a lid on longer dated yields. As the Fed progressively lifted the US Cash Rate the US yield curve flattened materially, but probably the most notable feature of the year was the lack of volatility, with US 10 year yields posting their lowest annual trading range since the 1960s.
Riskier assets were buoyed by the low volatility macro and policy environment and an improvement in cyclical profitability. Noise around the chaos of the White House, European populist politics and US-North Korea tensions (the battle of the bad haircuts) were only fleeting distractions.
With the global cycle steadily improving and little slack left in the major developed economies, the global macro economy appears set for a return to some degree of normalcy. Most economists would acknowledge that economic normalcy looks quite different now compared to 10 or 20 years ago, as demographics, technology, and in particular, debtload, have shifted. However, the policy cycle and markets are a long way from reflecting even downwardly revised estimates of economic equilibrium.
As the New Year begins, the main question on investors’ minds is – ‘Will continued strong global growth deliver higher inflation?’ For one thing, the global economy continues to exhibit a lot of positive momentum. Global financial conditions eased significantly in 2017, thanks mainly to higher equity prices and narrower credit spreads. Easier financial conditions will continue to support growth along with fiscal policy that should remain stimulatory throughout 2018.
One of the main surprises of 2017 was that inflationary pressures remained subdued across advanced economies despite diminishing slack. In the US the exceptionally low, and steadily falling US unemployment rate has not lead to a sustained lift in inflation. In fact several economists are calling the Phillips curve, the historical inverse relationship between the unemployment rate and inflation, dead. Research by the US Fed and our own analysis suggests when the unemployment rate falls below a certain threshold this relationship will re-assert itself and core inflation will begin to rise. This is expected to start early in 2018. The bottom line is that inflation will start to accelerate this year, with core inflation likely to be around 2.5% at the end of 2018. The expected economic environment also means that inflation pressures are also likely to continue into 2019.
With markets pricing in a benign inflation environment, we believe both risk assets and bond yields will initially be negatively impacted by a change in the inflation regime. Higher US inflation will prompt the Fed to raise rates potentially more than implied market expectations. A faster pace of accommodation withdrawal by central banks would also pose further risks to bonds and risky assets – keeping upward pressure on bond yields and a widening of credit spreads.
From our perspective inflation is the most likely fundamental cause of a turn in sentiment and policy. Our outlook for inflation and more generally the poor valuations for longer term bonds (implying pretty low returns going forward) keeps us defensively positioned across fixed income portfolios – with less interest rate risk vs the benchmark and modest exposure to credit risk. In rates, we’re holding about 1.25 years less duration than the benchmark. We’ve recently pared some Australian bond exposure following outperformance, leaving the aggregate relative to benchmark position distributed equally between short duration positions in the US (where the cycle is most advanced), Europe (where valuations are most extreme) and Australia. We responded to the aggressive flattening of the US yield curve by moving to position for a re-steepening. While Australia is clearly lagging the US cycle, if the global cyclical uplift continues to broaden as we expect, Australia will likely be pulled along with it. In addition, the prospects for policy tightening is underpriced in Australia and the RBA has indicated that the next move is likely to be up. Given this outlook we have continued to add exposure to inflation linked bonds and shifting our preference on the Australian yield curve from shorter to longer dated maturities. Both these positions should help protect against an upwards turn in the domestic cycle.
Credit markets continue to enjoy a sweet spot of improving cyclical growth prospects with little apparent fear of profitability or liquidity effects of central bank withdrawal. There is always risk with such a benign outlook, and these are now rising with spreads at post-GFC tights. Improving fundamentals are insufficient to justify such tight valuations when adjusting for lower quality and longer duration across most global credit indices. However, as yields generally remain low and central banks remain accommodative, it’s possible that risk assets will remain stretched and the reach for yield will continue to be a factor driving markets. That said, we think that risks are becoming more skewed to the downside with much of the favourable business cycle story already reflected in asset prices. A pickup in inflation combined with central bank withdrawal could just be the catalyst for a shift in credit markets.
Given this outlook we are holding a very modest absolute exposure to credit assets, a little above the benchmark weight, maintaining a strategy of accessing a small amount of ‘safe’ carry until better value is restored. During October we added back a little to domestic investment grade credit, at present our preferred fixed income asset for its high quality and short duration. Our exposure to lower quality domestic and global credit remains limited. We’ve also recently marginally topped up exposures to longer-dated semis and to AAA rated Australian residential mortgages, which have lagged the spread tightening of other sectors. Altogether this positioning is defensive as we patiently await the triggers for market volatility that should provide the opportunity to position more constructively.
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