Will lower for longer be the new normal?

August was a big month for bond markets as trade warfare, recession fears and broadening political turmoil set government bonds on track for their strongest monthly return since the heat of the 2008 crisis. The key concern for markets was that trade protectionism could drive the US economy towards an even sharper slowdown. The US yield curve inverted with 10-year yields trading below 2-year yields, a signal that has preceded every recession since the 1950s. The month also saw the amount of negative yielding debt in the world touch a new all-time high above $17 trillion.

Government bonds now look quite extended on valuation grounds. However, there are two key factors we see as possibly driving yields lower still. The first is that, with ongoing tariff escalation and unresolved geopolitical issues, we believe growth is likely to get worse before it gets better. Central banks are either not easing quickly enough or reaching the limits of what they can do.

The second is that riskier assets remain vulnerable, supported by expectations of central bank easing, and did not weaken much compared to the bond market rally. Credit and equity valuations remain reasonably full, and with earnings likely softening alongside global growth, are vulnerable to a repricing to the downside.

While fundamentals in the US economy have remained strong for the consumer and the labour market, we have concerns about more severe spill-over from weak global growth and trade policy uncertainties. Indeed, these headwinds have already contributed to a significant slowdown in the domestic manufacturing sector and business investment in recent quarters. At this point, easier monetary policy is required to provide ‘insurance’ against these risks. There is a risk that ‘insurance’ cuts won’t be enough to ward off a sharper slowdown, particularly if the trade war continues to escalate.

In Europe, investors are gearing up for a big bazooka of stimulus from the ECB. Markets are expecting the ECB to announce a new round of asset purchases, a deposit rate cut, tiering of the cash rate, and enhancements to forward guidance. Chances of fiscal stimulus have gone up, but this seems unlikely to be delivered until the Eurozone reaches crisis point. German manufacturing does not equate to broader Eurozone growth but weakness in the largest economy is seemingly driving the policy debate as well as asset prices. QE is now a regular policy tool in Europe, but it has never added to inflation expectations. The best that can be said is that it buys time. Co-ordinated monetary and fiscal policy is required in the Eurozone.

Australia’s situation is no different from the rest of the world in that despite solid growth for many years and falling unemployment rates, wages growth and inflation have been stubbornly low. Falling house prices alongside a very weak consumer has now delivered a large collapse in domestic demand. With below trend growth, low inflation and now a rising unemployment rate, we are expecting the RBA to take the cash rate below 1%. Lower-for-longer policy rates are now a reality in Australia and, with QE by the RBA also plausible, the local yield curve is beginning to behave like its European counterpart.

Over the past year we have significantly increased the portfolio’s duration, and this continued at the start of August. We have mostly been adding to our US duration position, which given the stage of the US cycle and the current policy setting, offers the best protection to downside economic risks. In Australia we have also added modestly to our long duration position as the RBA resigns itself to a lower-for-longer approach and the real possibility of unconventional policy. Europe is the market where we have taken profit on our long duration position in the back end of the yield curve given a lot is already priced for further policy stimulus. Alongside the duration changes we have switched some of our inflation exposure from Australia to the US and longer out the curve where there are positive real yields.

Our credit position is best summarised as being long in high quality Australian debt and short in lower quality global debt, which leaves us earning a small amount of extra carry versus the benchmark but positioned to capture some of the likely widening in credit spreads as market volatility increases. Our preferred allocations are to Australian investment grade and mortgages. We’ve also been seeking ways to maintain yield, diversify exposures, and efficiently manage risk. This is a challenge, as there are few pockets of value left; however, volatility does create opportunity.

Altogether the portfolio stands ready to navigate what appears to be a difficult environment ahead with economies fragile, but little room for policy error.

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