Slightly more benign prognosis

The uncertainty inherent in global markets was apparent in February with the “risk-off” trade that characterised the start of the month, reversing towards month end. The turn in sentiment primarily reflected some moderately better news on the global economy which shifted sentiment away from the idea that global recession and deflation was imminent, towards a slightly more benign near term economic prognosis.

There are a couple of points to draw out of this. Firstly, from an economic perspective, the more benign near term economic outlook fits more closely to our view of the world than that of the more bearish market participants. To be clear on this point we are not economic bulls, but rather with central banks still incredibly supportive of growth and fiscal policy globally no longer acting as a headwind to global growth we see little reason to expect the world (or any of the major regions – bar Japan) to slip into recession any time soon. Consistent with this, we have also argued that deflation remained a risk, but not the most likely outcome and that even some stability in oil prices would see core inflation in the US tick up. Certainly the tick up in the most recent readings on US core CPI and the PCE deflator would seem to be consistent with this.

While it has been easy to criticise the Fed over recent years, their recent rhetoric and actions seem more on the money and consistent with the most recent flow of data. They have clearly laid out their requirements to begin withdrawing the ultra-accommodative monetary stance and despite the ebbs and flows of data, sentiment and markets to date have held their ground. Rightly in our view. Markets are clearly spooked by the idea of further Fed tightening in light of the inherent challenges of the US and global economy, but are also prone to bullying the Fed in the sense that those arguing the loudest for the Fed to sit on their hands (or reverse course) are those that have benefitted the most from their policy largesse in recent years. Self-interest is a powerful motivator. Ultimately though the proof will be in the data and in our view the modest uptick in core inflation and the ongoing resilience of the US labour market argue for the Fed to continue albeit modestly edging rates up over the course of the year.

The alternate course now employed in Japan and Europe is a step into very dangerous territory. The logic of negative interest rates is that they should encourage consumption, as saving via bank deposits or bonds become very unattractive. The problem for the European banks though is that their costs are rising (they no longer receive interest on their reserves with the central bank – but pay) and depositors are reluctant to put money in the bank given the lack of return (or increasing cost of holding bank deposits). As a consequence the profitability of the banking sector in Europe has now been brought into question. Not a great base to be building a recovery. Part of the reason for the increased policy emphasis on negative rates has been deflation concerns. On this point, the fixation of the ECB on headline inflation is potentially creating precisely the opposite outcome that it is setting out to achieve. Time will tell.

Notwithstanding the comments above, the outlook for markets remains problematic and we do not disagree with the arguments for caution here. While we have seen some volatility in the major global equity markets, the price corrections have been insufficient to turn what were relatively full priced markets into attractively valued medium term investments. Valuations and medium term return prospects are better but not great. Where we have seen opportunity and acted has been in the high yielding debt markets. There are 2 ways in our view to access higher yield – step down in quality (sub-investment grade) or step down the capital structure (subordinated debt & hybrids). Both have presented good buying opportunities with spreads in high yield moving significantly wider on the declines in energy prices (we have been adding global high yield) and we have also been selectively adding some of the local bank Tier 1 subordinated securities. On balance these positions have been funded by cash.

On the defensive side, the outlook for sovereign yields is a dilemma. Modest rises in US core inflation, okay growth (2-3%p.a. real) and a Fed still on track to lift rates further should prompt a modest rise in US Treasury bond yields. The problem is that yields have disconnected from fundamentals as negative interest rates in Europe and Japan make US Treasury bonds attractive (even at low levels) making it hard for yields to rise. From the perspective of our multi-asset strategies, reconciling these issues is less important than in a dedicated fixed income portfolio as we advocate holding some duration in the event that we are wrong (does happen more often than I’d like) and deflation unfolds. In this environment Treasuries / duration will be the only place to be even if starting yields are already low.

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