Commentary: From defence to offence


2022 has been a challenging year across markets as central banks fight inflation through aggressively raising official interest rates and withdrawing liquidity. While central banks will likely keep raising official interest rates, forward-looking market pricing suggests this is already factored into the yield curve and we are moving close to the peak in rates. With inflation momentum appearing to have peaked, there is the potential for market focus to shift to the possible downside risks to the growth outlook and the risk of recession.

Uncertainty, however, still remains as to the level at which inflation will eventually settle. In past cycles where inflation has been above 8%, it typically stays elevated for longer and doesn’t return to as low a level as it was when inflation started to rise. While the pace of tightening has been very rapid, and we expect we are close to the peak, if inflation is more persistent we are likely to see rates higher for longer as central banks become more confident on the future path of inflation.

Moving portfolio positioning from defence to offence

What we have seen though, is that valuations have improved across many asset classes. As such we are moving from ‘defence’ to ‘offence’ as we position the portfolio more constructively to take advantage of opportunities and deploy the high levels of cash we hold in the portfolio. With current expectations of a shallow recession, it should favour both duration and credit-based assets, which gives us the confidence to deploy our cash holdings while keeping the risk profile conservative.

While we are adding risk back into the portfolio, we are focused on the higher-quality segments of the credit markets. Investment grade credit is broadly pricing a recession and with yields close to 5% in developed markets, it provides an attractive source of income for the portfolio. European investment grade credit is particularly attractive for Australian dollar (AUD) based investors, as we receive a yield pick-up from hedging the euro currency exposure back to AUD.

Keeping an eye on high yields

We continue to retain a zero holding in global high-yield securities. High-yield securities (those with a credit rating below BBB-) are not yet pricing in the risk of recession level defaults and as such may be vulnerable to further negative price adjustments. That said, the breakeven level given the outright yields may provide some interest for adding in the future, should we become more comfortable that expected defaults are manageable and the outlook for earnings is reasonable. 

On the duration side, we have been adding to portfolio duration as valuations have improved. Having moved to close to one year of duration, this has increased the portfolio’s yield and added some downside risk protection as duration has arguably improved as a risk hedge as inflation peaks. Given our wide duration range and global opportunity set, we are able to take advantage of higher yields available offshore.

Poised to make adjustments

As we continue to deploy cash from the peak holding of close to 50%, we do remain highly liquid and able to remain very active, making adjustments to portfolio positioning as we move through this next phase in markets.

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