The trouble in the March quarter began with markets fretting over an acceleration of US inflation, then morphed into concern around peaking growth, driven in part by escalating US-China trade tension. These concerns reflect what appears to be late-cycle deterioration in the growth-inflation mix. While some of the quarter’s volatility can be attributed to ‘technical’ factors, such as the triggering of stop losses by volatility sellers, higher inflation but stagnating (albeit still reasonable) growth is rarely an asset-friendly economic environment, at least during the adjustment phase.
Interestingly the adjustment to higher yields in the US that occurred over the quarter was not much explained by a repricing of term premia. While inflation expectations did increase a little, mostly the yield move was driven by a repricing of the Fed. Whereas markets had been skeptical in prior years that the Fed would deliver hikes to meet its ‘dots’ (with justification except in 2017), 2018 market expectations for rate hikes now match those of FOMC members.
While markets on the one hand seem to have renewed belief in the Fed, on the other they seem less enamored with Trump. The S&P500 rallied 31% without a monthly retreat from Nov 2016 to Jan 2018, but has fallen 6% since, as the focus of the administration’s policy agenda shifts from pro-growth tax and spending measures to fighting China on trade and Mexico on immigration. Even Trump’s lauded tax cuts are having some unintended consequences – the reduced taxation of repatriated profits appears to be disrupting money markets as funds that were previously held in short-term investments are being freed for other uses. With the Fed shrinking its balance sheet slowly, the US Treasury has added to short-end pressure by selling short-dated t-bills to fund a growing budget deficit.
Aside from political brinksmanship, rising inflation remains the most likely trigger for increased market concern. We don’t expect a 1970s-style escalation of inflation, but as output gaps are closed or almost so, we do expect sufficient inflation to drive policy withdrawal and market repricing.
The repricing in short-term funding spreads – relatively modest to date – is a reminder of the slow burn as policy rates rise and liquidity is drained from the system. Despite the volatility of February and March, market risk premiums remain low. For sovereign bonds, both higher expectations for inflation and policy rates, and increased uncertainty around their paths, should help restore term premium. For credit and equities, years of ‘search for yield’ behavior have compressed risk premiums, conditioned by both lower bond yields and low volatility. As policy is withdrawn, risk premiums should adjust, and the adjustment path is unlikely to be smooth.
While this adjustment period will be uncomfortable, in our view it should create opportunity to own both safer bonds and riskier assets, the latter with some comfort margin as recession still remains some way off. An even more difficult phase for riskier assets is likely to come later as policy eventually moves into restrictive territory.
We’ve been broadly expecting markets to reprice and volatility to lift for some time now, and positioning for it (at the cost of some performance while stability prevailed) by running below benchmark duration and a low credit exposure. With our expectation that inflation concerns would gather pace in early 2018, around the turn of the year we took further steps to protect the portfolio against repricing, by increasing the size of our short duration position, adding additional inflation linked bonds, and paring our credit exposure. Having seen yields rise and spreads widen a little, over March we added back a little to interest rate and credit exposures.
In rates, over March we trimmed our relative-to-benchmark short duration position from 1.65 years back to 1.40 years as some shorter-term indicators point to a consolidation in bond yields. However, while bond valuations have improved in both absolute terms and relative to other assets, we’re continuing to hold the bulk of our bearish interest rate positioning. The US has been the focus of much of our bearish rate view to date, with Australia preferred on a relative basis due to its lagged cyclical position, however the US is beginning to look more appealing. We’ve also been negative on European bonds given poor valuations and an improving cycle, but have been cautious about the size of our position pending more concrete evidence the ECB is prepared to tighten policy.
In credit, over March we added back to domestic investment grade exposure, in particular adding floating rate bank paper which widened in concert with short-term funding spreads. This takes the credit risk of the portfolio back to a little longer than benchmark, but still a modest absolute position. We continue to prefer Australian credit over global, for its high quality, short tenor, and relatively better valuation. Our small global and higher yielding (and riskier) exposures are effectively hedged, and while our expectation is that we’ll be adding back to credit should spreads widen meaningfully, we believe it’s too early to do so yet.
Altogether this leaves the portfolio well placed to deal with a widening of risk premiums and higher market volatility. Cash and liquidity in the portfolio is elevated as we wait for opportunities to invest more constructively, which we view as likely to occur as markets adjust to reflect a more normal economic and policy environment.
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