Lock it in Eddie
Yields on high quality fixed income are offering their best absolute and relative value in more than ten years. These yields can provide a great base for returns in future years, with the potential for material price gains should the cycle sour.
Authors
Goldilocks in November
After markets got a scare ahead of Halloween, the ‘higher-for-longer’ market narrative reversed towards a Goldilocks ‘soft landing’ in November. Inflation globally showed evidence of ongoing moderation, activity softened but not alarmingly, and central bankers shifted (mostly) to more neutral tones, driving strong performance across most asset classes.
Our business cycle models have been highlighting reduced, though still elevated, recession risks, and our inflation and policy rate models have been indicating that central bank policy rates are high for the expected future path of inflation. So in some ways the moves of November are not a surprise, and our portfolios benefited from them. From here we expect a continued softening in economic activity, and ongoing moderation in inflation to still uncomfortable levels. The likelihood of a mild recession is high, however as this cycle is proving unusual in several ways, there is a wide range of possibilities around this.
Almost certainly, the current collective market expectation – which with 100bps of rate cuts factored in the US and Europe next year implies central banks can declare victory on inflation with minimal collateral damage to the real economy – will not play out. More likely is either that inflation and hence rates stay elevated for longer, or that weakening of the economy accelerates and central banks reverse course more meaningfully.
For asset allocators, the good news is that in high quality fixed income, elevated yields can form a great base for good returns over time. They can also provide an excellent buffer for returns against price volatility over short periods. On current yields of xx%, our scenario analysis suggests high quality fixed income has only limited downside and potentially material upside insurance for portfolios.
While there is considerable uncertainty about how this cycle plays out, we are confident that central banks are very close to being finished with their tightening. This even includes the RBA, despite the hawkishness of new Governor Bullock, which hiked in November and could still deliver a final hike. This confidence informs our positioning in several ways.
Positioning
Our focus in recent months has been to add attractively priced yield to our portfolios.
Our asset additions have been in US mortgages, US inflation-linked (real) yields and emerging market sovereign debt, which have all cheapened considerably, driven by the US rate cycle and dollar strength. We closed our high yield short to lock in attractive yields (albeit spreads are about average). We also added duration, especially in Europe, and moved our yield curve exposures shorter, particularly in the US.
As we have locked in yields, with confidence that central banks are done tightening (all bar the shouting), we have been careful to ensure portfolios are well set for a variety of cyclical outcomes, and resilient over the medium term to a possible new regime of higher inflation and greater macroeconomic volatility.
Our key positions are:
- Overweight investment grade credit, particularly in Australia. This is a key way to access income from high quality assets at a reasonable price, and an attractive way to help build inflation resilience via sectoral exposure to infrastructure, utilities etc. We also like Australian bank sub debt, which currently sits in a sweet spot for return versus risk in the capital structure, given the strong Australian banking sector. Overall we prefer investment grade over high yield credit based on cheaper valuations, and as a safer harbour should the cycle weaken more meaningfully.
- Moderately overweight interest rate (duration) risk. Despite cycle uncertainty, yields appear to be peaking with the final hikes being delivered. We are long duration in Australia, Europe and the US, with a small short still in Japan. We will increase duration as the cycle turns
- Overweight inflation linked (ILBs) versus nominal bonds. ILBs are delivering higher income in the near term, given sticky inflation, and provide cheap longer term protection against inflation. We hold most of our inflation exposure in the US, where pricing is more attractive than domestically
- A preference for shorter tenors. This is particularly the case in the US and Europe where short dated yields are higher than those on longer maturities. This preference will likely help portfolios should central banks need to ease more rapidly than is priced, and also helps insulate them from higher volatility. In Australia, our preference is to be holding mid-curve exposure, in high quality spread product.
Learn more about the Schroder Fixed Income Fund.
Read the latest whitepaper from our Fixed Income team here: Characteristics of the ‘next’ economy and implications for Fixed Income and The current case for fixed income.
Important information: The views and opinions contained herein are those of the author(s) on this page, and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. This article is intended to be for information purposes only and it is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations. Information herein is believed to be reliable but Schroders does not warrant its completeness or accuracy. No responsibility can be accepted for errors of fact or opinion. Reliance should not be placed on the views and information in the document when taking individual investment and/or strategic decisions. Past performance is not a reliable indicator of future results, prices of shares and the income from them may fall as well as rise and investors may not get back the amount originally invested. Issued by Schroder Investment Management Limited, 31 Gresham Street, London EC2V 7QA, which is authorised and regulated by the Financial Conduct Authority. For your security, communications may be taped or monitored.
Authors
Topics