Commentary: Tension building
Growth and inflation tensions are causing volatility as markets anticipate interest rate cycles. China's economic downturn, particularly its imploding property sector, is causing global uncertainty. Despite this, investment grade corporates remain resilient, and high quality carry remains the focus in portfolio positioning, with adjustments in duration and currency exposures to mitigate risks.
As we have covered off in previous commentaries, the tension between growth and inflation and the reaction function of central banks would likely form the backdrop of higher volatility as the markets look to pre-empt the path of interest rate cycles. The current expectation is that central banks are close to finished with rate hikes. Inflation looks to have peaked and is rolling over and global growth is likely to weaken from here. That said, our view is that inflation will remain above that of the last decade. The reversal of disinflationary forces such as globalisation and the impact of decarbonisation are likely to see inflation remain sticky at levels above central bank targets. As a result, higher term premium will be required, given the greater uncertainty over the level of inflation, higher macroeconomic volatility and expectations of continued loose fiscal policy settings.
One development adding to market uncertainty over the past few months has been China. 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, foreign corporates are turning away from China and sourcing products from other countries, and are reluctant to invest due to heightened political risk. The government needs to embark on radical structural reform to provide a welfare safety net, but are restricted by their ideological beliefs.
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.
Corporates hang on
Interestingly, one of the features of the current environment is that investment grade corporate health appears to be holding up. While funding costs and input costs have increased, corporates have been able to pass on higher costs to the consumer through higher prices without a drop in demand. As such, the expected earnings air pocket has not eventuated at this stage. Factors such as a tight labour market and spending excess savings may be contributing to this.
In terms of portfolio positioning, our focus remains on high quality carry. Yields on investment grade corporate credit are delivering attractive levels of income and valuation levels are currently pricing in a recession. While we may get some spread moves driven by heightened macro volatility, the probability of a loss of capital from an event of default remains extremely low.
This is in contrast to high yield which is currently not pricing in a recession and is reflecting a benign default cycle. It is the high yield segments that are most vulnerable to the tightening in lending standards and higher debt costs. One interesting development in the high yield market is that much of the new issuance is secured, whereas previously it was unsecured. Given the heightened risk in the high yield segment, lenders are requiring security to provide capital. This means unsecured lenders will have less asset protection and lower recovery rates in a period where defaults are likely to rise. In our view, current valuations are not providing sufficient compensation for the expected rise in defaults.
Duration has been somewhat more challenging. We have been adjusting total duration, country exposures and the position on the yield curve. We have been reducing our US duration exposure in favour of Australia as we believe the RBA is closer to the peak in rates (particularly given the impact of recent rate rises on the mortgage market). We have also shifted exposure to shorter maturity bonds, which will be more driven by the domestic rate cycle.
On the currency side, we have retained our long USD and long JPY at 2% each as a downside risk hedge. Cash remains at 14%, which maintains portfolio liquidity. With a yield to maturity of 5.4% at month end, we see the Schroder Absolute Return Income Fund as continuing to provide high quality income via our defensive, diversified and active approach.
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