Commentary: Starting 2022 with a more defensive posture


Recent returns have been subdued given starting valuations and volatility in markets. Over the quarter credit exposure detracted from performance. Markets are fully priced and any weakness in risk assets has meant credit spreads have moved wider. The carry from the coupons was exceeded by the spread widening, the majority of which came from weakness in Australian credit assets.

Duration was a moderated contributor over the quarter. Whilst we hold minimal exposure to duration-based assets, we did benefit from holding some duration in Australia where we did see yields move broadly lower having retraced some of the selloff in the prior quarter. A short duration position in the US also assisted given the selloff in the front part of the US curve.

Foreign currency exposures were a small detractor over the month as the Australian dollar (AUD) was broadly stronger against both the US dollar (USD) and the Japanese yen (JPY).

Omicron continues to drive markets

As we close out 2021, COVID continues to dominate the news headlines. Case numbers are rising quickly with the Omicron strain, however it looks at this stage that the risk of overwhelming hospital systems is low. High vaccination rates and the roll out of booster shots appear to be working to reduce the risk of becoming seriously ill. That said the situation remains fluid as we continue to adjust to living in a world with COVID.

Key risks to markets continue to be the outlook around inflation and growth. Growth appears to have peaked from elevated levels and whilst slowing still appears to be above trend. Inflation is expected to peak in the first half of 2022. Against this backdrop there is concern that the fiscal pulse will be weaker going forward and that monetary policy settings remain extremely accommodative and will need to be adjusted. Markets are pricing in official rate increases, hence the recent volatility in sovereign bond yields, however the transition to more appropriate monetary policy setting has only just begun. The reaction function for the central banks around the actual timing and pace of the adjustment remains tied to the data which as we know can surprise and lead to spikes in volatility. 

Portfolio positioning

In terms of portfolio changes we have made a few adjustments over the quarter. We have been reducing overall credit risk and adjusting the mix of exposures. The reduction in global high yield was driven by expensive valuations. Whilst earnings continue to be strong, we do think there is some complacency creeping into this market. We also reduced exposure to emerging market sovereign debt based on the view that a stronger USD combined with challenges around lower vaccination rates in the developing world would be negative for emerging markets.

We did increase our exposure to Asian credit via our Schroder ISF Asian Credit Opportunities Fund. On a valuation basis this asset segment is the one that has the most valuation support. The risks, particularly around the Chinese property sector, do demand a higher risk premium which is arguably in the price. The Evergrande restructuring process looks to be orderly and the systemic risks from this asset class remains manageable. That said we are watching this space closely.

We also increased exposure to US securitised credit on the view this would continue to benefit from a strong US consumer. This combined with the fact it is a floating rate asset class means it should benefit from the current environment. Domestic hybrids also continue to offer a reasonable yield via a subordination risk premium and hence we have retained our holdings at this stage.

In terms of duration, we continue to hold low levels of outright duration given the views around bond valuations and the risk of more hawkish central banks. Over the quarter we have continued to reduce interest rate sensitivity in the portfolio and are currently at 0.25 years of duration. This reflects the view that the adjustment in interest rate expectations means duration-based assets are likely to remain under pressure. Compared to December 2020 where we were carrying closer to 1.7 years of duration, the significant reduction over the last 12 months has been a deliberate strategy to insulate the portfolio from expected moves higher in bond yields.

We do have cross market positions in which we are long duration in Australia against a short duration position in the US. The short in the US is where we believe the risks around inflation are most prevalent and the likelihood that the Fed will be forced to act sooner. In the US we also have exposure to yield curve flattening to reflect the expectation that expectations for official rate increases will cause shorter dated yields to sell off more than longer maturities. The small long in Australia reflects the view that inflation is more contained than in the US and the RBA’s reaction function will be more measured. It also does provide some downside risk protection if risk assets come under pressure.

In terms of foreign currency exposures, we have also made adjustments to the mix. We did take some profit on the long USD position. We added to the long JPY position on the view that the yen tends to provide the best downside risk hedge.

Cash holdings are elevated reflecting the desire for liquidity in the portfolio but also as a result of reducing credit risk but not adding to duration risk. We currently prefer cash over sovereign bonds, even at the low cash rates, given the desire to protect capital and the view that negative returns on sovereign bonds remain a possibility as we witnessed last quarter.

Outlook for 2022

Looking forward into 2022 we are once again in a period where markets are uncertain given the Omicron variant overlayed with the risk around inflation and the growth outlook. The risk of rising inflation appears to be fading into 2022 but central banks will still need to wind back liquidity support and lift official interest rates. This transition will be a delicate balance between adjusting policy settings and the economic uncertainty that will likely feed into market volatility. This policy adjustment is against a moderating growth profile. Whilst we do not foresee a recession, a slowdown is underway which the risk of the Fed entering into tightening cycle as growth is rolling over which can exacerbate the downside risk in markets.

Against this backdrop we remain defensive and liquid. The repositioning of the portfolio has been to focus on capital preservation at this stage of the cycle. With credit spreads fully valued, capital growth is less likely and we find ourselves in a carry phase. The uncertainly around the profile of normalisation of interest rates also means we do not favour adding duration risk. The adjustment process can hit capital values as we have seen in the past and hence we hold little exposure. Cash holdings are elevated and ready to deploy as market re-pricing provides better opportunities.

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