Commentary: We continue to play defence

Outlook remains uncertain

May was a comparatively better month for financial markets. This likely reflected the combination of easing inflation concerns and improved valuations, via higher risk premia, across many asset classes. That said, ongoing uncertainty warrants continued caution. On one hand you have the potential for the next 12 months to be characterised by a peak and subsequent fall in inflation, with supply-led growth that is likely positive for risk assets. The alternate case is one of rising recession risks and a concern around the growth and inflation outlook that sees volatility rise and negative returns from risk assets.

We see the balance of risk towards the latter with continuing challenges ahead. June sees the commencement of the Fed’s balance sheet run off (quantitative tightening), with the liquidity withdrawal building to a rate of USD$95bn over a few months – a rate that is almost double the USD$50bn monthly reduction they undertook in 2018-2019. It’s not a stretch to say this unprecedented speed of liquidity withdrawal, together with further official rate increases, will likely have a material impact on economic growth with the potential to have unintended consequences.

We are also witnessing a global squeeze on many supply chains exacerbated by war, COVID-19 lockdowns, supply bottlenecks and of course excess demand. The impact of increasing energy, transport, food and debt costs is having a meaningful impact on US consumers, who are already drawing down their savings. The US savings rate has plummeted, and stress is beginning to show, for example in the US subprime car loan market where loan delinquencies have now hit an all-time high. This is occurring despite wages increasing at the fastest pace in years, especially for the lowest paid workers.

Dealing with downside risk

The combination of the above factors makes it clear that US companies are likely to face headwinds to meet sales margin expectations this year. We continue to monitor inflation, monetary policy, geopolitics and of course supply chains, and while many parts of the market have already experienced a downward re-rating, we believe there is still a skew towards additional downside going forward.

It is against this backdrop that we remain defensively positioned, with a focus on managing downside risk. Our absolute return approach allows us to navigate a variety of market conditions. Given the ongoing uncertainty, and despite increasing risk premia, we have maintained very high levels of cash, low outright duration risk and we continue to reduce credit risk. The recent rout in bond markets reinforces the importance of active duration management. Due to our interest rate hedging overlay, we have mostly insulated the portfolio from the effect of rising bond yields and focused on preserving capital.  Importantly, our active approach also allows us to progressively add duration back into the portfolio as term premia increase and valuations improve.

We have continued to reduce our credit exposures and the holdings we have retained are high quality, with an average investment grade rating. Active stock selection also serves to limit the likelihood of capital loss from defaults, which is particularly important as we do expect default rates to rise. We have used credit derivatives to create a negative exposure to global high yield, which will provide a positive offset to wider credit spreads. We have also cut most of our exposure to emerging markets.

 The counterbalance to low duration and reduced credit allocations is higher levels of cash and short-term investments, which currently stands close to 45%. This is the highest in the history of the portfolio and reflects the fact that cash is capital stable and more importantly liquid. It provides option value and the ability to easily take advantage of opportunities as they arise.

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 last month and initiated a long US dollar position. We believe this will be a cleaner risk hedge compared to the yen, which has suffered as the Bank of Japan maintains control of the yield curve and has kept Japanese 10-year yields under 0.25%.

Opportunity ahead

Looking forward, the positive side of recent moves in asset prices is that valuations have improved across a variety of asset classes. As term premia and credit risk premia rebuild, opportunities will emerge to invest the large cash holdings we have accumulated and move away from such a defensive footing. We have invested in shorter maturities (out to three years) in Australian sovereign bonds where we see current yields as reasonably attractive, relative to our expectations for RBA policy tightening. We will look to add more duration to the portfolio when we believe the risk vs return dynamic moves further in our favor. On the credit side, we are remaining patient in the belief that recession risks have not yet been fully priced into credit markets and better entry points are still ahead. We retain our focus on capital preservation and are alert to opportunities as they arise.

Learn more about the Schroder Absolute Return Income Fund.