Commentary: The balance of risks is shifting more positive for fixed income returns

Central banks have collectively embarked on their sharpest tightening cycle ever in the last six months. There is as yet no definitive evidence that underlying inflation pressures are subsiding, nor that economic growth is meaningfully cracking, however risks are building in that direction. Significant asset repricing is beginning to create value, particularly in fixed income, given the likely downshift in the economic cycle.

Our key cyclical views are:

• Persistence of inflation remains the dominant influence. Markets have largely priced ‘success’ by central banks in bringing inflation back closer to target, whereas our assessment is that inflation may stay stickier for longer.
• Labour markets remain tight and corporate profitability in aggregate has not yet slipped meaningfully. Although policy tightening has been abrupt, the impact through to the real economy is taking time.
• Together we believe a true ‘pivot’ by central banks to more accommodative policy settings will not be forthcoming for some time. Although central banks are acknowledging a slower pace of tightening is required from here, fighting inflation is still being prioritised over concerns about recession risk.
• The RBA is one of the more balanced central banks in its approach - including employment and financial stability goals alongside a thru-cycle inflation target - and was the first to step back the pace of tightening. While Australian sovereign bonds have outperformed peers as a result, the broader Australian market remains heavily impacted by the RBA’s unconventional easing program.
• Although markets are likely to cheer a slower pace of tightening in the short term, macro uncertainty is likely to remain elevated. We remain cautious that markets are too optimistic that central banks can bring inflation back to target and deliver the ‘soft landing’.
• This environment should favour higher quality assets. Higher quality assets, including government and high-quality corporate bonds, have underperformed year-to-date, driven by the rates repricing.
• We believe most of the rates repricing has occurred, and that higher quality corporates now offer attractive yield levels for medium-term investment horizons. Australian investment grade credit stands out as particularly appealing given its high risk-adjusted spread.

Fund positioning

While we aren’t yet signaling the ‘all clear’ after what has been a tumultuous year, we determine that fixed income now stands out as offering good absolute and relative value. The cyclical picture is becoming more supportive of bonds, as risks shift from upside inflation towards downside growth. In a broader portfolio sense, fixed income is now likely well placed to offer low-risk income and diversification.

• We have moved from a small underweight duration position back to neutral by taking profit on most of our short positions at the very front of yield curves. Our bias is to further increase duration as we look for evidence that inflation is moderating and growth materially slowing, however we expect to be patient in doing so.
• In general, we continue to expect yield curves to flatten as rates are hiked. However, divergence between yield curves is offering some relative opportunities – the US curve, for example looks too flat relative to other countries.
• Credit faces a very uncomfortable macro mix, with downside growth and profitability risk adding to liquidity headwinds. However, spreads have moved significantly wider already, and while we believe riskier credit is still vulnerable, higher quality corporates offer good prospective returns, especially on an all-in-yield basis. In October we increased our exposure to investment grade credit, and reduced some of underweight positioning in high yield.
• We are being even more patient in adding to credit than to duration. We will become more constructive as recession risks are increasingly priced.

We are now optimistic that better fixed income returns are ahead and that fixed income will retain strong strategic value to portfolios. We are confident that our portfolios are well placed to deliver on both, and we are carefully becoming more constructive in our portfolio settings.

Learn more about the Schroder Fixed Income Fund.