February revealed the first cracks in the relative market stability of the last year, as higher inflation fears both drove bond yields higher and risk assets weaker. While some of the abruptness of the market moves during the month can be attributed to technical factors, such as the requirement of risk parity funds to shed risk as volatility moves higher, we think there are broader underlying economic causes, and that it’s likely the higher volatility is here to stay.
Output gaps (meaning excess economic capacity) in many of the world’s leading economies are closed or almost closed, the first time since the GFC that the global economy has been in this position. The best evidence for this is the tight state of the labour market in many countries. The closure of output gaps suggests we are now entering a phase where economies operate more normally – meaning inflation should respond to growth. To be sure, ‘normal’ looks quite different now compared to the pre-GFC environment, particularly as debt saturation limits the capacity for credit-fueled growth. However, if inflation follows growth (regardless that they are both subdued relative to prior cycles) it suggests that policy should normalise too, and therefore so too should markets which have benefitted from so much policy intervention.
The Fed seems to have reverted to type. Hampered for so long by the zero lower bound to normal policy settings, and therefore ‘unconventionally’ accommodative to deflation fears and financial fragility, the world’s key central bank appears to now be following an older script. Our work suggests that the Fed’s projected path for rates is back to following Taylor Rule models (which suggest the official cash rate should be varied from neutral according to variations in inflation from target and output from potential). The US is leading the global economic cycle, and its central bank provides a template for global monetary policy developments. We expect other economies and central banks will follow the US trajectory in due course.
From our point of view it’s therefore correct for markets to worry about US inflation. We don’t think we’re in for a 70’s-style escalation of inflation, but rather a late-cycle deterioration in the growth-inflation mix, potentially made worse by trade wars. So for us the concern is not runaway inflation per se, but rather the implications of higher inflation for policy withdrawal and market pricing.
Despite the volatility of February, market risk premiums remain low. For sovereign bonds, both higher expectations for inflation and policy rates, and increased uncertainty around their paths, should help restore term premium. For credit and equities, years of ‘search for yield’ behaviour have compressed risk premiums, conditioned by both lower bond yields and low volatility. As policy is withdrawn, risk premiums should adjust, and the adjustment path is unlikely to be smooth.
We’ve been broadly expecting this to occur for some time now, and positioning for it (at the cost of some performance while stability prevailed). With our expectation that inflation concerns would gather pace in early 2018, over the last few months we took further steps to protect the Portfolio against repricing, by increasing the size of our short duration position, adding additional inflation linked bonds, and paring our credit exposure. At the end of February, we had 1.65 years less duration than the benchmark, 0.6 years in the US (where the cycle is most advanced), 0.4 in Europe (where valuations are most extreme), with the balance in Australia. These positions are mostly held at the 10yr point of respective yield curves, in-line with our view that the term premium needs to rise hence longer dated bonds should underperform. We continue to prefer Australian over global duration given the lagged cyclical position of the domestic economy, and hence hold considerable absolute duration in Australia, however we view Australian bonds as susceptible to the improvement in the global, and ultimately domestic, cycle.
Early in March we bought back a little duration, as some of the shorter-term indicators point to a consolidation in bond yields. However, while bond valuations have improved in both absolute terms and relative to other assets, we’re continuing to hold the bulk of our bearish interest rate positioning.
In credit, we’ve effectively hedged our global investment grade and domestic higher yielding exposures, leaving the credit risk of the Portfolio about neutral to benchmark, a very modest absolute position. We continue to prefer Australian credit over global, for its high quality, short tenor, and relatively better valuation. Other parts of the spread universe that have relative appeal are domestic mortgages, shorter duration supranationals and longer semis, though all segments are at risk of some near-term repricing. With recession still some time off, our expectation is that we’ll be adding back to credit should spreads widen meaningfully, though we believe it’s too early to do so yet.
Altogether this leaves the Portfolio well placed to deal with a widening of risk premiums and higher market volatility. Cash and liquidity in the Portfolio is elevated as we wait for opportunities to invest more constructively, which we view as likely to occur as markets adjust to reflect a more normal economic and policy environment.
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