Defensive but ready for action
We remain defensively positioned across the portfolio as the debate about whether inflation is transitory or structural continues to rage.
Inflation is currently the hot topic for discussion and front of mind for many investors. In May we witnessed a large spike in inflation as consumer prices in the US rose 4.2% year-on-year to April (beating expectations of 3.6%) driven largely by pent-up demand and supply-side constraints.
Whilst the market reaction to the inflation data was subdued, one could argue it had already been somewhat priced into bond markets. The recent rise in bond yields had been pricing higher inflation risks and as such the inflation data was a validation of the market moves to date. That’s not to say all is calm under the surface. The question is whether we are facing a structural lift in inflation or if it is transitory in nature. Have central banks finally been able to generate inflation following a 30-year disinflationary trend?
Those suggesting more transitory inflation argue the supply-side constraints are temporary and will be resolved through a supply response as supply chain issues are resolved and workers return to the workplace. The spike in demand will also be temporary and will fade after the initial rush for holidays and eating out is satiated. The disinflationary forces for the past 30 years will re-assert.
Those arguing for sustained inflation suggest that emergency monetary policy settings combined with large amounts of fiscal stimulus being pumped directly into the economy will continue to stoke demand and increase consumption. This combined with supply side constraints and rising labour costs mean price pressures are inevitable. These factors could be exacerbated by the Fed allowing the economy to run hot and being slow to increase interest rates when required.
At this stage it is not clear whether the lift in inflation will be transitory or structural and this may take some time to play out. What we do know is that from this starting point many markets look fully valued. Alongside inflation there are other factors, including China-US tensions or a growth scare, that can cause market to reprice and volatility to spike. Ultimately this is important across different interest rate, credit and FX markets, and the relativities between them.
Our portfolio positioning remains defensive. On the interest rate side, we maintain a low level of duration and hence the portfolio has low interest rate sensitivity should we start to see markets price in rate hikes. We have 0.35 years in Australian duration exposure, and 0.11 years in the US along with some emerging market bond duration. Specifically, regarding inflation exposure, we initiated a trade to take advantage of some mispricing on the yield curve for inflation-linked bonds. We sold 0.25 years of inflation exposure at the 5 year maturity, which based on our analysis, is over-valued and should contribute to the portfolio should we see medium-term inflation expectations fade.
On the credit front, we are mindful that valuations are moving into expensive territory across many markets and that we are in the carry phase of the current cycle and have low expectations for further credit spread compression. This, however, is not an immediate trigger to reduce current exposures. High levels of liquidity in the market, low funding costs, manageable leverage and default rates appearing to have peaked all suggest credit spreads can move sideways. We have seen this in the past where in the absence of a catalyst in or shift in the cycle markets remain benign.
Our corporate exposures are at 64% of the portfolio and diversified across global markets. We continue to access risk premia across Australia, Europe, US, Asia and emerging markets. We hold investment grade and some sub-investment grade bonds as well as securitised exposure and subordinated hybrids. Over the month we did increase our hybrid exposure at the margin and reduce investment grade credit.
We made no material adjustment to currency positions over the month and retain a small long position in the US dollar and Japanese Yen for downside risk protection.
Overall, we remain defensive with an investment grade average rating. We are carrying low interest rate sensitivity and our foreign currency positions are moderate. We remain liquid but importantly active and alert to opportunities as markets move forward.
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