Commentary: Goodbye, cruel QE world

As we embark on the second half of 2023 we see a once in a decade opportunity to be back allocating to fixed income from a cyclical perspective, and to review diversification as bonds appear to be a more effective hedge.

Bond markets are saying goodbye to the cruel old QE world. An environment of low growth and low inflation meant cash and bond yields were anchored at low levels, where low yields = low returns. We have now entered a higher yield regime driven by higher real growth and higher inflation. We believe higher yields will mean better prospective returns from fixed income and greater diversifying potential, especially given some asset classes are yet to adjust

For now, the ‘income’ is back is fixed income. We have seen a huge restoring of value across the entire fixed income universe – over the last 18 months Australian government bond yields have doubled, Australian high quality corporate bonds are now yielding around 5% and the riskier segments of the fixed income universe like global high yield and emerging market debt are yielding between 8-9% (hedged to A$). Value has been restored from not only an absolute perspective but also in relative terms compared to other asset classes like equities and alternatives.

The cycle looks to be turning in favour of bonds. Inflation is moderating and growth is slowing, reflecting the drags from monetary policy tightening. US recessionary indicators are elevated with all parts of the US yield curve pointing to a high chance of recession over the next 12 months.

Looking beyond the current opportunity in fixed income is the ‘next’ economy. We believe the next decade will look very different to the GFC/QE decade, and that it will require a structural shift in portfolios where fixed income plays a more important role. A higher for longer regime where inflation resets while growth remains soft enhances the strategic value of fixed income. We believe fixed income will provide strong defensive qualities in an uncertain environment:

1. Higher yields should provide robust income generation.
2. Higher volatility means a premium adjustment will be required in riskier assets.
3. High quality fixed income will be an attractive store of liquidity.

Positioning

The market has been pricing a higher path for policy rates over the last month as the strains in the banking system have not worsened, a deal to raise the US debt ceiling has been reached and economic data has surprised to the upside. Despite some better than expected global data, traditional signposts of recession continue to flash red.

Markets are now pricing in cuts before year-end without any material implications for growth. Yet we believe central banks will only cut interest rates if we definitely enter a recession, or if stresses in the banking system increase and / or credit markets deteriorate significantly. What’s more, the interest rate cuts currently in the price implicitly assume that inflation will fall at least to 3%. That is possible, but not without significant growth implications. The prospects for continued disinflation are good but not guaranteed.

Most asset classes are priced for simultaneous good outcomes on multiple fronts, however we think risks are elevated. The magnitude and duration of defaults in the next downturn are likely to surprise investors. The tightest monetary policy in 15 years is running into elevated corporate leverage, built upon stretched profit margins. Investors are likely to be disappointed by the lack of central bank support they receive in the next recession. With inflation remaining above targets, this will raise the bar for future quantitative easing. A higher for longer regime will keep corporate financing costs higher than expected through a downturn.

In an environment where growth takes longer to normalise from a post-pandemic shock, our portfolio preferences are as follows:

A bias towards high quality bonds, both government bonds and investment grade credit.

As we look to position for the peak in the interest rate cycle, we have been accumulating interest rate risk in those markets that are showing signs of disinflation (i.e the US). Australia and Europe are yet to see a clear moderation in core inflation and are around six months behind the US cycle. In both these markets we are positioned for the Reserve Bank of Australia and European Central Bank to take the cash rate above 4%, underperforming the US.

Our credit allocations have been concentrated in high-quality Australian investment grade. This asset class is the most attractive to us on a risk adjusted basis, compared to other global corporate bond markets. Its high quality bias and short tenor also make it appealing to us vs riskier credit sectors that are vulnerable to material repricing. We continue to hold net short positions in both US high-yield and US investment grade.

Market volatility in both rates and credit is expected to remain high as we approach the turn in the economic cycle. We are liquid and defensively positioned, holding a larger allocation to cash. This will provide greater flexibility to get more constructively positioned in our portfolios if valuations improve, especially in the more risky segments of the global fixed income universe.

Learn more about the Schroder Fixed Income Fund.