IN FOCUS6-8 min read

Commentary: The bond market marches to a different beat

Global equity prices fell and bond yields rose in the wake of a more hawkish Federal Reserve statement announcing the decision to maintain current policy settings. With more cracks appearing in the US economy and with our recession models still flashing red, we believe that the policy tightening cycle is more likely done and the next move will be rate cuts in 2024.

03/10/2023
Fixed Income Fund Commentary - different beat

Markets have closed the September quarter with equity prices lower and government bond yields significantly higher, with broad global equity and global bond indices posting negative returns over the quarter. Buoyed by the resilience in the US economy in the second quarter, equity markets continued to price a soft landing; the scenario where the Federal Reserve (Fed) successfully brings inflation back to 2% while avoiding recession. This would enable the Fed to end the tightening cycle and shift to rate cuts in 2024, benefiting equities. With victory over inflation, the soft landing narrative should also have been supportive for bond markets. However, bond markets didn’t read the same script and sovereign bond yields continued to march higher, particularly for longer dated maturities. During the quarter, higher bond yields started impacting equity valuations with prices peaking at the end of July. Equity prices continued to decline and bond yields continued to rise following the Fed’s September meeting, during which it kept policy settings unchanged as expected, accompanied by a far more hawkish statement than anticipated. While markets have called the victory over inflation, the Fed hasn’t and the message was clear; rates could be lifted again and are going to be held higher for longer.

Holes appearing in the safety net

We remain negative on the outlook for growth. Our recession models have been flagging high risk of recession in the US for some time now, but it has been the resilience of the US consumer and expansionary fiscal policy that has kept US economy stronger than we expected and seemingly immune to higher interest rates.  Thanks to COVID-19 stimulus payments, US households were able to accumulate US$1.8bn in excess savings which helped provide a buffer to these increases in prices rather than relying solely on their wages to make ends meet. Today these excess savings are mostly depleted, removing an important safety net for households. We have also seen debt levels rise, such as credit card debt per household making new highs, and deferred repayment programs end, such as the moratorium on student loan repayments, which points to a consumer becoming stretched in the coming months. The level of the US Federal budget deficit is currently close to 8% of GDP and is unprecedented – except in times of recession and war. Together with higher spending on social security, healthcare, defence, and education, President Biden has been able to push through legislation which has provided massive incentives (such as tax credits, loans and subsidies) to corporates designed to spark development of a domestic cleantech and semiconductor supply chain. This fiscal pulse is expected to decline substantially into 2024. So the two factors keeping growth above our expectations are expected to have less impact going forward. In addition, the oil price has reversed and is up 30% from its lows. Higher oil prices act as an additional tax on the consumer and will likely be a negative for growth.

In Australia, evidence is growing that households are buckling under the pressure of higher interest rates. Australian retail sales growth remains tepid, and is negative over six months after adjusting for inflation, despite surging population growth via immigration. This is consistent with very depressed consumer sentiment levels. In the same vein, job vacancies data is showing the labour market continuing to soften. Whether core inflation reaches the Reserve Bank of Australia (RBA)’s implied forecast of 0.9% quarterly increases is questionable though, and this keeps a further rate hike in the frame for November’s meeting. Over the past month, shorter term interest rates have moved higher (although far less than longer term rates) with the implied probability of around 50% for another increase in 2023. In its September statement, the RBA noted “some further tightening of monetary policy may be required to ensure that inflation returns to target in a reasonable timeframe, but that will continue to depend upon the data and the evolving assessment of risks.” If the RBA does move again, this will only increase the probability of a much weaker economy in 2024 and should benefit fixed income markets in the medium term.

Shifting exposures

As highlighted in previous commentaries, sovereign bond yield curves have been shifting shape. Shorter term yields have been far more stable, reflecting the view that central banks have mostly completed their policy adjustments, but long terms yields have been increasing substantially as markets became increasingly concerned over structurally higher inflation and the enormous US Treasury issuance program required to fund the federal budget deficit. As a result, yield curves have been steepening and unwinding the significant inversion, particularly in the US, UK and European markets. We recognised early in the quarter the risk of higher yields for longer dated US Treasuries and the impact this would have on other markets, including Australia, and have been busy reshaping the duration exposures of the Fund. Along with cutting total duration exposure from a high of 2.0 years in June to 1.25 years at the end of September, we shifted exposures away from the US, towards Australia and Europe, and shifted exposure away from bonds with maturities greater than 5 years. These changes have significantly reduced the negative impact of higher bond yields (lower bond prices) on the Fund’s return. In addition we have retained a short position in Japanese bonds and benefited from yields increasing as the BOJ loosens their yield curve control policy, and have recently initiated a short position in UK gilts over concerns regarding the size of the gilt issuance program.

Credit markets have been far more stable and returns from credit indices were positive over the quarter, despite higher sovereign yields due to the shorter duration exposure and higher income from the credit spread. We were far less active in credit and increased credit risk marginally by reducing credit derivative hedges and adding to Australian investment grade corporate exposure via new bank issuance. The credit quality of the portfolio remains very high, reflecting our positive view on investment grade credit from the level of credit spreads, combined with higher outright yields underpinned by higher sovereign yields across the yield curve. While we expect volatility in both credit spreads and yields, overall compensation for risk remains reasonable, providing portfolios with lower risk income. Within investment grade, we prefer Australia and Europe, where spreads are much wider and offering compelling value (cheap to very cheap), pricing in a recession, relative to the US market where investment grade spreads have yet to widen materially. Exposures to high yield bonds remain neutralised by credit hedges as we believe spreads are too narrow for the growth risks ahead and increasing risk of default. We have retained smaller exposures to US securitised assets and emerging market sovereign debt as yields remain attractive at 7.3% and 8.0% respectively. The portfolio’s yield to maturity at quarter end was 5.6%.

Outlook remains favourable

Going forward we expect continued strong returns from the Schroder Absolute Return Income Fund. Under our expectations for slowing growth and falling core inflation, central banks are likely very close to completing their policy tightening cycle. This should be supportive for fixed income markets, particularly for shorter maturities and in regions where growth looks weakest. Our largest exposures are in Australia and Europe and we expect to increase duration risk back towards 2 years as confirmation of weaker growth unfolds. We remain concerned about longer maturities, particularly in the UK and US, where the issuance program to fund deficits is enormous and have hedged these duration exposures. Investment grade credit markets should continue to provide stable returns in our preferred scenario, but we remain ready to reduce credit risk if the economic data confirms a deeper growth slowdown.

Learn more about investing in Schroder Absolute Return Income Fund.

Topics

Fixed Income
Australia
Bonds
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