Steady as she goes for the global recovery


The most notable market development during February was the dramatic rise in longer dated bond yields across most markets and the consequent dramatic steepening of yield curves. Round one of the arm-wrestle between financial markets and central banks has commenced!

The exact trigger for this move which resulted in the near doubling of 10-year bond yields in Australia (trough to peak) isn’t clear. That said, it has its foundations in the layering of very expansionary fiscal and monetary stimulus on top of a broadly improving global economy and increased confidence in the vaccine roll-out. This aggressive, pro-cyclical policy stance is increasing the uncertainty about the trajectory for inflation – and with the risk to inflation seemingly skewing to the upside, markets are starting to question the ability of central banks to maintain current policy settings for an extended period. Bear in mind the RBA has stated publicly (and recently re-iterated) its intention to keep rates low until 2024 at the earliest, and the US Federal Reserve has publicly committed to run the US economy “hot” for an extended period. While the current monetary policy regime gives central banks relatively good control over the front end of yield curves (including in Australia’s case the direct targeting of 3-year bond yields), it’s much more difficult for central banks to control rates further out the yield curve where the factors influencing yields are much broader.

Equity and credit market volatility increased as the bond market meltdown became more unorderly, but weakness was short-lived with investors continuing to back the ability and willingness of central banks to hold the ship together. Under the surface, though, some cracks have opened. Most notable were those areas of the market where high valuations have been the most evident. Technology stocks in particular have continued to re-price, reflected in a 10% decline in the Nasdaq (at the time of writing) compared with a more moderate 4% decline in the broader S&P 500. Consistent with this from an equities perspective, rotation towards value stocks and away from growth stocks continues (albeit there is clearly a significant premium remaining in growth stocks).

One key question that investors remain split on is the broader valuation debate in equities. Current price to earnings yields (P/E) in most markets are high relative to their history (suggesting more moderate future returns) but the more bullish interpretation is that this reflects a combination of record low (and likely persistently low) interest rates and expectations of strong future earnings growth as stimulus fuels economic recovery. Certainly, on our growth numbers, if forecast earnings for 2021 are realised in the US (for example) then market valuations are not cheap, but more reasonable. Likewise, low interest rates make the earnings yield on equities look much more attractive than simple P/E comparisons would suggest. The rise in bond yields has eroded some of this attractiveness, but low cash rates and narrow credit spreads mean the impact has been relatively modest to date.

Another key consideration is the P/E gap between growth stocks and value stocks. Clearly not all equities are expensive, and growth stocks have had a strong tailwind from low bond yields, so a growth to value rotation is possible without derailing the overall market. The fact that the recent rise in bond yields has had a greater impact on growth stocks is consistent with this rotation towards value.

A material rise in longer dated bond yields was not unexpected. Our duration positioning has been significantly reduced from a high of 2.75 years in February last year to 0.75 now. Our view was the risks to yields had become asymmetric (ie, not much downside to yields, but plenty of upside). Positioning for steeper yield curves was more problematic given the small amount of duration we hold is more for downside protection then for return potential. This clearly highlights a key challenge of the current environment, namely, how to hedge risk when sovereign yields are suppressed and the risk is skewed to the upside in yields. Currency remains a strong alternative, particularly to help mitigate equity market corrections, but our analysis continues to support the idea that the US dollar remains an effective hedge for Australian dollar-based investors. But in February Australian bond yields increased more than US yields, which supported the Australian dollar (AUD) for much of the month – dragging down the strategy’s performance given our long foreign currency positioning, which is largely held for downside hedging purposes.

The strategy continues to be positioned for moderate performance from risk assets as policy settings remain favourable for ongoing global recovery. Our positioning will benefit from the continued rotation in equities towards value stocks and we remain liquid to take advantage of higher volatility in equity markets

Equities

The sharp increase in bond yields in the second half of February was the trigger for a sell-off in equity markets. Growth stocks, particularly technology companies, were the hardest hit. Despite this, strong returns in the first half of February driven by a continued recovery in earnings in both the US and Europe and the rotation towards value and smaller capitalisation stocks saw most equity markets produce positive returns for the month. Global equities returned 2.7% in local currency terms, while the Australian market underperformed with a return of 1.5%. The MSCI World Value Index outperformed the Growth Index by 4.3% throughout the month.

With valuations remaining somewhat stretched, and our expected returns remaining low across most equity markets, we reduced our equity weight by 1% in February down to 24%. This was implemented through a blend of Australian and global equities. The 1% was re-allocated to fund an exposure to commodities futures, which we expect to continue to perform strongly through a global recovery and also act as a potential inflation hedge. We also continued to add out-of-the-money put option spreads to provide some protection from small to medium sized market corrections.

Fixed Income

Global bond yields continued to rise through February, particularly for longer dated maturity bonds in the US and Australian markets. Ongoing quantitative easing and yield curve control by central banks, including the RBA, as well as the likely approval of the US$1.9 trillion stimulus package by the US Congress, has seen the market price in higher growth and inflation expectations. This saw Australian 10-year yields jump by 0.79% to end the month at 1.92%, while in the US 10-year yields jumped by 0.33% to end the month at 1.40%. With yields on shorter dated maturity bonds still anchored by low cash rate targets, yield curves in Australian and the US have steepened significantly over the last few months. In credit, global investment-grade and high yield spreads tightened moderately over the month, while in Australia and in emerging market debt yield curves were flat.

Through February, we trimmed our investment-grade credit allocation by 1% as spreads continuing to tighten. In addition, while the relatively high duration of the asset class makes it more vulnerable to an increase in yields, we think the risks are skewed to the downside. We have chosen to redeploy into our allocation to insurance-linked securities (ILS) by an additional 1%. The underlying economic risks for ILS are generally uncorrelated with the broader business cycle, and the gross yield of 5-7% remains relatively healthy. Overall portfolio duration remains defensive at 0.75 years.

Currencies

 The British pound (GBP), continued its recent run of strong performance, while emerging market currencies and JPY were the underperformers. We have mixed views about the US dollar. While valuations remain challenging, the strong growth outlook for the US against the rest of the world – and the high level of short positioning among speculators – could see the US dollar rebound over the shorter to medium term. Foreign currency exposure in the portfolio remains unchanged at 22%.

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