Credit markets gain strength as policy support lingers
Credit markets gain strength as policy support lingers
The resolution of the US election and positive news on the progress of two vaccines were catalysts for November’s very strong performance in both equities and credit markets. The strength of that performance surely now sets 2020 apart as literally the year that had everything for markets. No-one would have predicted that most equity markets would be higher and yield spreads on credit instruments would be narrower than where they started the year, given the extent of the COVID-19 hit to the global economy.
Why have markets done so well? The simple answer is that policy makers this time around have been very committed to limiting the damage to both markets and the real economy – supporting markets with effectively free and unlimited funding, together with asset buying backstops, and bolstering the real economy with unprecedented fiscal policy income support and infrastructure spending. This has effectively removed the negative (“left tail”) of the return distribution for risky assets like equities and credit. When current prices are discounted, taking out negative possibilities lifts the average expectation of future outcomes higher.
Policy support likely to linger
Markets also realise this support may last longer, as policymakers indicate they are committed to maintaining support not just in terms of magnitude, but also time-frame. The Federal Reserve’s switch to average inflation targeting – which means they won’t increase rates as early as they would previously have done – is the most obvious example of this. So, with rates staying at effectively zero, borrowing costs for corporates and consumers will remain low for longer.
Will widespread rollout of one or more vaccines reduce the magnitude and time-frame of the policy support? Perhaps the real economy will eventually get back to normal levels of activity, albeit with some meaningful compositional shifts, but the policy support is likely to linger. If this is true, markets can be excused for thinking all news is good.
Bond yields drift higher
Alongside the strong performance in equities and credit, bond markets have reacted adversely and yields have begun to drift a little higher. Our shorter-term price signals have recently shifted negative on bond prices and medium term valuation models suggest yields are too low. Naturally, we’ve been debating whether this is the start of a sustainable move higher for bond yields. Our view is that yields are likely to go higher over the next year, but probably not materially so.
Although this conclusion sounds negative, we do nonetheless think it’s worth protecting portfolios against the possibility the move higher in yields is material. The cost of doing so is relatively low, and bonds are less likely to offer the same degree of portfolio insurance as previously. As a result, we have been reducing the interest rate sensitivity of the portfolio, mostly by reducing exposure to US Treasuries, including positions that benefit from steeper yield curves and US treasury under-performance against other regional bond markets. .
Our credit valuation signals, having correctly indicated a strong buy in March, are now almost back to expensive territory. When should we reduce our credit exposure? The fundamental picture is still improving for corporates, and should continue to improve as the recovery progresses. This improvement provided the rationale for us to upgrade our view of credit a few months ago.
With economic recovery largely backstopped by policy support, it is ironically an environment of stronger growth, higher inflation, and concern about monetary policy tightening that would be the worst economic environment for credit. This would likely be a bad environment for many portfolios, as riskier assets would suffer at the same time as defensive assets.
Our portfolio position
Currently, we are continuing to focus on our sector and individual stock selection opportunities in credit. We are rotating out of assets and sectors that have performed well and are now overpriced, and into those that have lagged but will benefit from economies reopening.
At an asset class level, the underperformers include most higher risk credit assets, especially Asian and emerging market debt, as well as consumer debt classes, including mortgages. At a sector level, the transport and property sectors, which had the largest negative impact from COVID-19 shutdowns, offer value in a scenario where vaccines are effective.
By rotating positions in the portfolio in this way, we are backing the ongoing recovery, but are not yet positioning for higher inflation. Nonetheless, we remain vigilant at both a macro-economic and corporate level for signs of pricing pressures.
Having performed strongly this year, the fixed income portfolio remains well positioned to continue to deliver. We believe firmly that fixed income continues to provide some very important portfolio building blocks – namely, quality income generation and diversification benefits. However, a shifting policy landscape combined with low yields suggests we will need to stay adaptive to the environment, a lesson well learnt from this year. We’ll set out how we believe managers should adapt in next month’s commentary. Until then, given the year we’ve had already, we’d like to wish everyone a safe December.
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