Waiting on the sidelines
We believe credit markets are in a carry phase with limited prospect for capital growth in the near term. Investors should resist the temptation to search for higher yields and shift into lower rated, higher risk credit products at these extremely high valuations.
At the time of writing, much of Australia has re-entered lockdown with the ongoing spread of the Delta strain of COVID. The Federal Government is in pursuit of zero infections with a target of 70% of adults vaccinated but it's not clear when that threshold can be reached. Vaccinations are ramping up although coverage for younger more vulnerable cohorts is much lower. There appears to be little appetite for immediate reopening given the current elimination goal. Despite the lockdown, the Reserve Bank of Australia (RBA) has not delayed its plan to reduce the size of its quantitative easing program given its optimistic medium term outlook for Australia. On the interest rate front the RBA continues to guide to a 2024 timeframe for an increase in official interest rates.
Outside of Australia, spread volatility was driven to some extent by a regulatory clampdown in China and potential solvency issues in a Chinese property developer. The Chinese Communist Party (CCP) is focused on reducing inequality and boosting demographics, which is the backdrop to its latest regulatory move forcing the lucrative for-profit education sector to convert to not-for-profit entities. Education costs are a major expense for Chinese households, with some estimates showing household education spending as high as 30% of incomes as more than 60% of primary school students receive additional tutoring outside of schools. By reducing the costs associated with the education sector, the CCP aims to improve wealth for the masses and promote additional births (due to lower spending in raising children, which it hopes will offset China’s ageing population).
Also in China, the second largest property developer by sales, Evergrande, has concerns around its solvency and the potential systemic risks should regulators allow it to default. Asset sales are continuing in an attempt to shore up the balance sheet, however, uncertainty remains as to how the government will act in the face of ongoing risks.
Despite these events and the moves over the month, the current starting point is many markets remain fully priced with limited potential for capital gains resulting in subdued future returns. With ample liquidity present in the system and the recent strong earning season in the US, the shorter-term optimistic outlook is to some extent warranted. That said, the growth outlook appears to be softening which may raise questions about peak growth and peak corporate earnings. At the end of the month the US Federal Reserve’s annual Jackson Hole Economic Symposium could also deliver additional tightening policy announcements and additional uncertainty.
For investors seeking defensive income not much has changed. Cash rates are stuck at or close to zero which continues to push investors into higher risk, lower rated credit assets in the search for yield. Credit continues to be an important source of return, although we believe we are in a carry phase with limited room for capital gains moving forward. The moves over the month serve as a reminder that downside risk management and diversification remain key, and the temptation for investors to buy complex structured products with embedded leverage at these valuations should be avoided.
Portfolio remains steady in July
In terms of portfolio positioning there were no material changes over the month. We continue to prefer investment grade credit and still see value in holding asset classes like US securitised debt, global investment grade credit and Australian credit (both senior and subordinated). We have also retained our small allocations to global high yield and emerging market debt. These provide yield to the portfolio however the higher potential volatility means our exposure is currently limited at these valuation levels.
Valuations in Asian credit markets appear to have improved given the spread widening resulting from the events in China. However, when you dig deeper it is limited to a handful of names and hence, we have not increased our position at this stage. We do believe that the higher yields provide good compensation for the higher volatility and uncertainty in this sector, although we are watching future developments closely before we add to the exposure.
In terms of interest rate exposure we retained a short US inflation position designed to take advantage of some mispricing on the inflation curve. In our view pricing appears elevated and should contribute to the portfolio should we see medium term inflation expectations fade.
In terms of overall duration positioning we continue to have low sensitivity to movements in interest rates. The low level of duration aims to ensure the portfolio will be insulated should interest rates and bond yields rise.
Our currency positions are expressing two key views. Firstly, as previously highlighted we have long US dollar and Japanese yen exposures combined at 3%, aimed to assist the portfolio in the case of an equity market dislocation impacting credit markets. We also have a small long British pound and Euro versus the Australian dollar which is designed to provide exposure to the reopening trade in Europe compared to the current Australian situation.
Overall, we remain defensive with an investment grade average rating. We are carrying low interest rate sensitivity and our currency position is designed to improve portfolio diversification. We remain liquid, but importantly active and alert to opportunities.
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