Waiting for the fallout

We continue to expect downside economic risks will dominate markets for some time, even as central banks are easing policy and there are signs US–China trade tension may be thawing. Unfortunately, much of the damage of tariffs and tight US policy, at least relative to the rest of the world, is already in the pipeline, which means policy shifts need to be more proactive to counter the fallout. While the fallout to date has mainly been in global manufacturing and trade, the clear risk is that it spreads to services, where the developed economy jobs largely reside.

We would be more optimistic if policy stimulus were delivered more comprehensively. While the ECB and the RBA have eased considerably, their cry for more help from fiscal policy has to date been unanswered. The PBoC are easing but seem determined to avoid a significant reflating of the Chinese property sector, while the Fed have been hesitant in committing to anything beyond ‘insurance’ cuts. Recent turbulence in the US repo market is most likely a sign that US policy is too tight, with liquidity unable to move quickly to where it needs to be. Whether there is anything more sinister under the surface remains to be seen.

We’ve been closely watching US recession indicators to gauge the magnitude of the economic slowdown, and consequently how concerned we should be for riskier assets. We still think recession is some time off, but with activity expected to slow further in the near term that timeline could be shortening. Valuations remain reasonably full on most riskier assets, perhaps supported by too-optimistic earnings expectations. Given the backdrop, that suggests caution is warranted.

A more general point on riskier assets concerns the way broader portfolios are constructed in a low yield world. Low yields imply low growth, which does not reconcile with sustainable high earnings nor high expectations of returns. Our recent Global Investor Survey revealed that people still expect to earn 10.7% on their investment portfolio over the next five years, and for Australian investors this number was higher still! Expectations appear in need of downwards adjustment to reflect the reality of a low yield, low growth, low return world. Consequently, this may reinforce demand for safer, more reliable, streams of cashflows – which high quality bonds can provide – even if the yields on offer are low.

Australia has well and truly joined the low yield club with the RBA cash rate now sub-1%, and the local market getting excited by the prospect of QE. We still think this is some time away, but while it may be distant, it is nonetheless a distinct possibility. We’ve been positive on Australian interest rate risk in absolute and relative terms for some time, but with yields lower and spreads to other countries having compressed, the opportunity is more nuanced now. In general, we think compression between yield curves and credit spreads is most likely to continue in a low risk environment, but that managing beta risks will be more challenging and the generation of alpha will be more valuable. Hopefully we are well placed on both.

Our ‘downside risks’ view sees us continuing to hold more duration than the benchmark and remaining cautious on credit. The duration position has ranged between 0.40 years and 1 year longer than benchmark in recent months, and mostly we’ve favoured Australian and US rates, but we had a modest long and flattening position in the German yield curve until recently. As well as moving the aggregate duration position, we’ve also been active in our exposure to the US yield curve, most recently moving our exposure back to the front end of the curve in expectation of more aggressive Fed easing. Given the stage of the US cycle and the current policy setting, US duration offers the best protection against downside economic risks. We are also holding a reduced allocation to inflation-linked bonds largely as a tail hedge to upside inflation risk.

We’re overweight in high-quality Australian credit, which remains a relatively favourable return-to-risk proposition, but short in US high yield, which is vulnerable to softer growth and rising earnings and default risk. This leaves us earning a small amount of extra carry versus the benchmark, but able to capture some of the likely widening in credit spreads as market volatility increases.

It will be a challenge to maintain yield, diversify exposures and efficiently manage risk in a low yield world. However the portfolio is well positioned for the environment we envisage.