Caution needed in a world awash with liquidity
Caution needed in a world awash with liquidity
COVID-19 continues to grab headlines around the world. On the positive side, vaccinations administered globally surpassed 1 billion with several countries achieving vaccination levels of over 50%. However, the downside is clearly evident in a number of countries in particular, India, where daily new infections are numbering over 360,000, the worst of any country since the pandemic began. The death toll underscores the serious nature of the unfolding humanitarian crisis. The impact on the global economy and supply chains by what is effectively the fourth pandemic wave in India is unclear at this stage.
So far, meaningful inflation in the developed markets has not emerged. There is some anecdotal evidence, such as soaring lumber prices, but higher inflation is yet to be reflected in the broader data. That said, expectations for a revival of inflation appear universal from policymakers and investors. Instead, it is now a question of how high, for how long and how will central banks respond? The inflation story and the uncertainty it brings is important in terms of asset values as higher inflation erodes future value.
In today’s environment of ultra-accommodative monetary policy and historically large amounts of fiscal stimulus, we are concerned that misallocations of capital will be inevitable. Distortions in the market are many, varied and flowing through into numerous asset prices. This is even dawning on the Twitterverse, with one user noting that “Moderna created a lifesaving vaccine in record time and is worth $70 billion. Dogecoin became a meme and is worth $87 Billion.” Inflated asset prices and speculative investments suggests caution is now warranted in a world awash with liquidity.
In the case of the credit markets, the ease with which companies can raise large amounts of cheap capital can be a double-edged sword. On the upside, the ample liquidity allows businesses to ride out the difficult times as a result of COVID-19 in the hope they will emerge stronger when some form of ‘normal’ returns. On the other hand, there are also companies that will no longer be viable, limping along until a catalyst for default emerges. These “zombie” companies are on borrowed time, being kept alive by the liquidity injection – but are unlikely to survive in the new normal. It is this second type of company that is concerning from a credit perspective because this is where capital can be easily destroyed. The unlimited downside and the limited upside of debt investments reminds us that capital preservation through the avoidance of defaults is key.
It is against this backdrop that we are cautious given valuation levels, but not bearish given the levels of liquidity and stimulus in the economy. The rebound in the markets from the pandemic lows occurred quickly in comparison to other recoveries due to the large and rapid fiscal policy response. Looking forward, returns will be more difficult to come by and an active approach rather than allocating to passive market credit betas will become increasingly important.
Fundamental bottom-up credit research is needed to avoid the “zombie” companies which are not paying the credit premium to reward investors sufficiently for the risks been taken. From a top-down perspective, this requires active management; rotating positions and adjusting sizing across the global opportunity set as events unfold. Implicit in this is the focus on managing downside risks.
Seeking stability in unstable times
In terms of how we are currently positioning the portfolio, at the broad level we maintain a high-quality bias with an average rating of A-. Cash is at 18% because it provides liquidity and is capital stable. Corporate exposures are at 64% and provide solid income in the form of coupons (this is predominantly investment grade companies in the US and Australia). We also have an allocation to subordinated risk premia in hybrids and an exposure to US high yield companies totaling 5%. Securitised credit, emerging market debt and Asian corporates round out the key income-producing exposures.
In terms of duration, the overall level remains low at 0.63 years. This reflects the concern that bonds are still susceptible to a further rise in yields and hence we prefer to keep a low level of interest rate sensitivity in the portfolio. We have wide duration ranges to manage through both rising and falling interest rate environments. Over time we envisage reducing the credit risk in the portfolio and adding to duration-based assets should bond yields provide sufficient reward for the inflation uncertainty. We took profit on our Australian bonds that are linked to the inflation rate given the favourable move in pricing.
Foreign currency exposures have been trimmed with the key positions being 1.2% in USD and 1.5% in JPY. This reflects the near-term benefits of liquidity in the system. Should we move to a more bearish stance, we would look to increase our foreign currency exposure in particular to the USD.
Overall, we continue to believe in a valuation-driven, active approach to investing that uses a broad opportunity set. This is focused not only on meeting return targets, but also on managing downside risk as the best way to deliver a defensive income stream for clients in the current environment.
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