Commentary: Rebuilding interest rate exposure
June may have marked a turning point for bond yields as the market focus shifted from inflation to concern over growth. We have responded by increasing the Fund’s duration risk, as bond yields are likely to be supported. Credit assets remain a concern as default risk increases while recessionary risks rise.
Outlook remains challenging
The reprieve for financial assets in May was relatively short-lived with the rout in equity and credit markets resuming in June. As the market focus shifts from inflation risks to the growth outlook and rising recession risks, equities and credit struggled while bonds prices benefited with yields on government bonds generally lower into month end.
Bond market volatility, as measured by the MOVE index, has spiked and remains elevated and close to levels during the pandemic. This highlights the challenges around duration-based assets and uncertainty around the reaction function of central banks as they attempt to walk the tightrope between managing inflation and the slowing growth outlook. The chance of central banks engineering a soft landing is, in our view, remote as they find themselves having to tighten monetary policy into a slowing economy. Central banks were caught napping and needed to play catch up by raising official interest rates quickly. This makes the task of managing inflation, without causing a recession, a difficult one. In the US, history shows us that every Federal Reserve rate tightening cycle since the 1970s has led to a recession of some sort. There is a high probability that central banks will need to pause and ultimately be unable to tighten as much as the market originally anticipated.
With inflation pressures potentially peaking and growth slowing, the earnings outlook for corporates will be key in this next phase of markets. Equity analysts continue to forecast higher earnings this year, however it is not clear to us how this will be achieved, given cost pressures and potential falling demand. Corporates have been enjoying the tail winds of a healthy US consumer and large amounts of liquidity in the system, which has allowed volumes to increase and margins to expand. Arguably, these tailwinds have now become headwinds. With pressure on the US consumer leading to weaker sales growth and other factors – including anecdotal evidence of an ensuing inventory glut – we expect weaker earnings going forward. Clearly some of this expectation is already in current prices, with equity markets down circa 20% year-to-date, but we expect more negative price pressure as earnings fade.
What’s being priced in?
In credit markets where defaults have thus far remained low, earnings pressure leading to higher default risk could push spreads wider. That said, within different credit markets there is some dispersion as to what is being priced in. When we look at valuations based on our Rock Bottom Spread (RBS) metric (the breakeven spread level for a particular default and recovery scenario) investment grade credit has moved to price in recession-like spreads. That is, if we do enter a recession and default levels rise, investors are arguably being compensated for potential loss due to default. That is not to say that spreads won’t go wider, but at current levels, a mild recession is in the price.
High yield (HY) bonds on the other hand have not moved to such an extreme. That means if we do move into recession and default levels rise off very low levels, there is currently insufficient risk premia for loss, given default. The reason for this is partly compositional, in that US energy companies make up a reasonable portion of the issuers in the global HY index and have performed very well, given high energy prices. In any case, we don’t see high yield issuers as cheap and hence have derivative positions that create a net negative exposure (ie the Fund will benefit from further spread widening in HY).
Over the past few months, we have continued reducing exposure to credit assets, building up cash and maintaining low levels of duration. We believe cash was preferable to credit which is susceptible to spread widening and also preferable to duration-based assets, given the rising rate environment and the rise in bond yields that impacts capital values. More recently, we have been increasing duration exposure to take advantage of the higher yields and also in response to rising recession risks. When sovereign yields were extremely low, the power of duration as a risk hedge was very poor – hence we held very low levels. As yields have risen and recession risks have increased, we have begun to rebuild duration into the portfolio.
Liquidity equals flexibility
We continue to hold elevated levels of cash and short-term securities. The benefit is that liquidity provides flexibility to change strategy as required. We have seen liquidity evaporate in many markets, especially in credit, so having true liquidity in cash assets affords us an advantage when we do wish to buy credit assets again. Short-term cash yields have risen significantly as the RBA has raised official rates, with three-month bank bills yielding 1.91%, a significant increase from 0.08% back in March.
Currency continues to be a downside risk hedge, given duration has been ineffectual, however we are holding minimal exposures. We removed our Japanese yen position earlier in the quarter and initiated a long USD position. We believe this will be a cleaner risk hedge compared to the yen which has depreciated sharply as the Bank of Japan pursued yield curve control.
Looking forward, the positive side is that term premia and credit risk premia are rebuilding and we are seeing opportunities to invest the large cash holdings we have accumulated. We have been reinvesting some cash across the Australian sovereign bond market where we see current yields as reasonably attractive. We will look to add more duration to the portfolio when we believe the risk vs return dynamic moves further in our favour. On the credit side, we remain patient in the belief that recession risks have not yet been fully priced into the riskier segments of credit markets and better entry points are likely. We retain our focus on capital preservation and are alert to opportunities as they arise.
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