Proceed with caution
We remain defensively positioned as credit spreads stay at multi-decade lows and equities continue to hit record highs. And while a reduction in bond purchases by the US Fed is unlikely to derail markets, we remain alert for any policy surprises.
In Australia the lockdowns continue, although the path out appears to be becoming clearer. As we move towards the goal of reopening the plan hinges on achieving certain vaccination levels in the population. Meeting certain thresholds allows for relaxation of restrictions as we have seen in other countries. Living with COVID is the strategy going forward, as the elimination of more infectious variants appears to be unachievable.
Key issues in global markets continue to revolve around inflation risks and the timing of Federal Reserve tapering of asset purchases and potential interest rate increases. During the month the US Federal Reserve economic symposium in Jackson Hole was a key focus. Chairman Powell stuck to the script, indicating the goal of “substantial further progress” had been met on the inflation mandate, but not on employment. That said, he noted “clear progress” in labour markets had been made and that the Federal Open Market Committee’s (FOMC’s) economic outlook is consistent with curtailing asset purchases “later this year”. This would imply a strong signal about tapering in the months to come.
Inflation remains a key risk to markets, although Powell reiterated he viewed current price pressures as transitory and that inflation should go back “to levels consistent with [the Fed’s] goal of inflation averaging 2 percent over time”. Powell concluded by stating that “if the economy evolved broadly as anticipated, it could be appropriate to start reducing the pace of asset purchases this year.” He explicitly separated the decision to taper from the timing of the first rate hike, which has been telegraphed to be a long way off – especially given economic data appears to have peaked and COVID risks linger.
The muted reaction from financial markets following Jackson Hole reveals that investors are prepared for a tapering announcement before year-end and suggests that a reduction in bond purchases will not derail markets (as has occurred in the past). The weaker-than-expected non-farm payrolls following Jackson Hole supports a pushing out of tapering of asset purchases. An announcement is likely to come at the November or December FOMC meeting, but the Fed is likely to favour a cautious approach. Any policy surprise would be around a faster-than-expected pace of tapering or an earlier-than-anticipated rate hike which appears unlikely in the near term.
Impact on investors
So what does it mean for investors seeking income? Cash rates are expected to stay close to zero in the near-term meaning investors that are seeking income continue to face challenges. Credit risk premium is compressed, and duration-based assets are likely to come under pressure if there is a policy surprise or strong payrolls emerge.
Our view is that investors should remain cautious considering that equities are at or close to all-time highs, credit spreads are at multi-decade lows, and the path of duration-based assets is somewhat uncertain. We do believe that from this starting point many markets look fully valued. Alongside inflation, other factors – including China-US tensions, a growth scare or withdrawal of liquidity – can cause market to reprice and volatility to spike. Ultimately, this is important across different interest rate, credit and FX markets – as well as the relativities between them.
From a portfolio perspective we made some minor adjustments. In terms of currency exposures, we exited the long EUR and GBP positions. These were originally implemented to back the European reopening trade given the faster vaccine roll out and associated loosening of restrictions. Given the pace of vaccine roll out in Australia and the plan to reopen, the relativities have largely played out. We have retained the long USD and JPY positions to act as hedges against risk asset weakness.
Credit position was largely unchanged. We did increase our Asian credit exposures marginally. Asian credit has come under pressure recently largely due to a regulatory crackdown in China in a number of sectors. From a valuation perspective Asian credit is by far and away the most attractive. US securitised credit continues to look reasonable value. We are cautious on US high yield valuations and are watching for any potential catalyst to cause spreads widen. With very little room for further spread compression we are looking to earn the interest rate carry at this stage.
Duration positioning was largely unchanged. We hold low levels of duration at the total portfolio level. Of this we have a long position in Australia. We are short duration in the US on the view that upward pressure on bond yields is likely if we see structural inflation risk rise or the Fed adjusts its narrative around tapering. We have also retained our short exposure to inflation-linked securities in the US at the 5 year part of the curve.
Overall, with credit risk premiums compressed, the Schroder Absolute Return Income Fund remains defensively positioned with an investment grade average rating. Reflective this positioning we are carrying low interest rate sensitivity and our foreign currency positions have been reduced. We remain liquid but importantly active and alert to opportunities as markets move forward.
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