Commentary: Collision course
Some of the themes from our longer term structural research, particularly the reversal of very long term disinflation factors such as globalisation and demographics, are already impacting market pricing. This is coinciding with a weaker shorter term cyclical outlook for both growth and inflation as tighter monetary policy starts to impact on household and corporate demand. This creates a potential collision between opposing forces on inflation and bond yields.
Recent increases in longer dated sovereign bond yields (more than 10 years to maturity) are starting to reflect the growing belief that the longer term structural influences that pushed inflation below 2% in the last decade are reversing. This is very significant as sovereign bond yields are the benchmark return for risk free investments. For investors to consider other potential investments – equities, property, credit – expected returns need to be above the sovereign bond yield. This higher expected return is the risk premium for taking on the potential for capital loss. Increases in long term bond yields are therefore critical for the outlook for all asset class returns and if long term bond yields continue to rise, asset prices for equities, property and credit will be under pressure to adjust lower.
Until recently, the largest increases in bond yields has been in shorter dated maturities as these bonds are the most responsive to tighter central bank policy and this has resulted in a historical inversion of yield curves (where short maturity yields are well above long maturity yields), particularly in the US and Europe. Over the last two months, a significant change has occurred; longer-dated maturities in developed market sovereign bonds have been increasing, with yield curves steepening. In US Treasuries, 30-year bond yields have risen 0.5% while 2-year yields are close to unchanged. In Europe, longer dated bond yields are up 0.25%, while 2-year yields have declined by 0.2% and in Japan, longer dated bond yields have increased by 0.4%, with 2-year yields increasing only by 0.1%. Shorter maturities are reflecting expectations for central bank policy to remain on hold, with a bias to easing policy in 2024, as inflation continues to decline and growth weakens. Typically, with this outlook, longer term yields would follow shorter term yields lower, but they have risen.
Long-term trends reversing
Earlier this year, we held our Strategic Investment Conference to consider the longer term structural influences on the economy, the potential for a post-COVID regime shift and the implications for asset markets. The key conclusions were 1) that the long term structural disinflation forces of globalisation and demographics were likely to reverse in the decade ahead and together with the impact of decarbonisation, would see inflation averaging well above that of the last decade and 2) government policy would likely shift from tight fiscal and easy monetary policy of the post Global Financial Crisis period to dominant (or loose) fiscal policy and tight monetary policy. The implication was higher sovereign yields due to higher core inflation, a higher neutral rate of interest (the real rate of interest that has neither a negative or positive influence on growth) and higher term risk premium (higher yields for longer maturity bonds). Term risk premium was crushed in the last decade as central banks deployed quantitative easing, inflation was very low and stable, growth was below potential and fiscal policy was on the sidelines. We believe the shift in yield curves over the past two months is starting to reflect a broadening in these ideas, and is most apparent in the higher term risk premium investors are now demanding for longer term bonds. Higher term premium is a result of greater uncertainty over the level of inflation, higher macroeconomic volatility and loose fiscal policy.
Complicating the outlook for bond yields is the fact that cyclical influences are now more favourable for lower yields. This is setting up a collision with the longer term structural influences for higher yields. In most economies we are seeing signs that the monetary policy tightening over the past 18 months is starting to impact aggregate demand and the labour force and with core inflation continuing to decline, central banks are now most likely on hold. The cyclical factors have a greater influence on shorter dated yields than the longer term structural influences. Fortunately we were quick to recognise these shifts and we think it has further to play out. Over the past two months we have maintained our interest rate exposure, but have significantly shifted that exposure away from longer dated bonds (10 year plus maturities) to shorter dated bonds (2 year maturities); we have also shifted exposure away from those economies performing better (the US) to regions where the impact of tighter monetary policy is likely to be greater (Europe and Australia). Most of our bond exposure is now focused in the 2 to 5 year sector of the yield curve. We believe these adjustments have insulated the portfolios from the increase in longer dated bond yields and the shorter dated bonds should benefit most from more evidence of weakening growth as central banks pivot from tighter to easier policy.
China’s crisis of confidence
The other significant development over the past few months has been the growing realisation that China has a very serious confidence problem. We see the experience of COVID and government clampdowns on different sectors as having shattered both household and corporate confidence and that they are very reluctant to spend or invest. The property sector (which at its peak represented circa 30% of China’s GDP) is imploding under massive debts and very low sales, creating negative feedback loops into retail investment products of the large shadow banking sector, many of which are now defaulting on distributions. In addition, we see that foreign corporates turning away from China and sourcing products from other countries and are reluctant to invest due to heightened political risk. To revive ‘animal spirits’, we believe the government needs to embark on radical structural reform to provide a welfare safety net, but are restricted by their ideological beliefs. Interest rate cuts, a weaker currency and reducing barriers to home ownership are unlikely to help.
A weak China has broad implications for their main trading partners, Asia (including Australia) and Europe in particular. China is the Eurozone’s largest export market and the European economy is most probably already in recession. China is also Australia’s largest trading partner. Under the weight of higher mortgage and rental expenses, Australian nominal household spending growth is the weakest since 1991, despite record levels of immigration. Both Australia and Europe are likely to be negatively impacted by the current state of the economy in China. Our equity exposure remains at 23%, protected by 10% of put options. However, due to China concerns we have rebalanced our regional equity exposures, reducing Australia and emerging markets and increasing the US weight. Exposure to Europe was already negligible.
Global growth likely to weaken
Our view remains that global growth is likely to weaken more than the consensus view, however we recognise that the US economy remains resilient, supported by government spending. In addition, it is less impacted by tighter monetary policy (due to fixed rate mortgages and corporates extending their borrowing) and weakness in China, than other regions. As a result we have increased equity exposure to the US and significantly reduced interest rate exposure (particularly in longer dated maturities), with the reverse occurring in Europe and Australia. In credit, we continue to believe high yield corporates are very vulnerable to a weakening growth outlook and the credit risk premium is insufficient compensation for this risk. Higher quality investment grade credit remains our favoured allocation with credit spreads providing a premium sufficient to cover the low risk of default even in a recession.
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