In January the global market party continued. Global equities ripped higher and credit spreads tightened further while bond yields rose, as investors factored in the good news of the US tax plan and the continued firming of global growth. We’ve been upbeat on the global cycle and well positioned for the move higher in yields, but relative to markets are much less euphoric. For us, markets are overlooking the consequences. The US tax plan is being applied to an economy already at full employment – higher inflation will follow. Higher inflation in its own right is destabilizing for a range of assets, but also is set to come at a time when the valuations of most financial and real assets are stretched. Central banks, underpinning asset prices for so long as they sought to stabilize and lift inflation, have overstayed their welcome at the party despite their tentative steps towards the door over the last year.
As we write in early February, already the market environment appears to be changing, with the realization that in a world of higher inflation and diminished central bank support, risk premiums need to be higher. This applies to both safer bonds and riskier assets. It’s unlikely this occurs in an orderly fashion – i.e. volatility is also likely to rise alongside risk premiums – and what we’ve witnessed in early February is likely to be a precursor of more to come.
This is not to say we are doomsayers - the global cycle is at its healthiest point in a decade, underpinning corporate and government cashflows. However, as the global cycle returns to cyclical normalcy (as output gaps are largely worked off), policy settings and market pricing require re-adjustment towards normal. In our minds a sooner resetting would be healthy, in order to minimise the damage when the next downturn – in the real economy or markets - occurs.
Our focus for the likely trigger for a resetting of expectations has, for some time, been inflation. Its absence over the past year in spite of growth uplift has allowed central banks to stay accommodative for longer and the low-volatility carry-friendly environment to prevail. Undoubtedly the structural changes in the global economy limit longer-term inflation, however they don’t completely override cyclical variations. While wages are likely less responsive to changes in labour market tightness than previously (i.e. the Phillips Curve is flatter), we still expect US core inflation to pick up meaningfully this year to around 2.5% as the labour market tightens further. And with other major economies not too far behind the US’s cyclical lead, the global inflation pulse is set to lift.
Central bankers should respond for two reasons. Firstly, although there is an argument they will be prepared to tolerate a degree of inflation overshoot (given the underachievement of inflation objectives for so long), inflation is a persistent phenomenon, against which policymakers should be forward looking. Secondly, to the degree central bankers have incorporated financial conditions into their policy deliberations, with financial conditions currently buoyant now is an appropriate time to ease back on the throttle.
Our expectation was that early 2018 would be the time when inflation concerns gathered pace, and as such over the last several months we’ve been taking further steps to protect the portfolio against repricing. As at the end of January, we now have 1.6 years less duration than the benchmark, having sold US and Australian bonds in December and further US and German duration in January. Of our relative short, 0.6 years is in the US (where the cycle is most advanced), 0.4 is in Europe (where valuations are most extreme), with the balance in Australia. These positions are mostly held at the 10 year point of respective yield curves, in line with our view that 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. In addition to shortening duration, we have also increased our direct exposure to inflation protection via US Treasury Inflation-Protected Securities (TIPS).
Similarly in credit, around the end of January we pared exposure further from an already cautious starting point, trimming both Australian investment grade exposure and hedging our Australian higher yielding position. With our global credit exposure already effectively zero, this leaves the credit risk of the portfolio about neutral to benchmark, a very modest position given the lack of credit in the benchmark. 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.
Altogether this positioning leaves the portfolio well prepared for a reset of risk premiums and associated market volatility, which in turn would provide an opportunity to position more constructively.
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