Dodging potholes on the road to recovery
2019 has been a very strong year for fixed income returns. Only one year ago the consensus was for higher interest rates, with the concern that higher bond yields would result in negative returns on fixed income. Instead, it has been a year of tug-of-war between political conflict and macroeconomic policy. The negative business shock from trade conflicts has had the upper hand for most of the year, with manufacturing being at the heart of the global slowdown driving bond yields lower.
Recently, there have been tentative signs that the global business cycle is stabilising and potentially turning up. Central banks have added stimulus by cutting interest rates and global manufacturing is showing improvement. This could set the stage for a recovery in global growth next year. As was the case with the last global slowdowns (the European crisis of 2011/12) and the emerging market credit unwind in 2014/15), we expect global growth to rebound broadly, led by an upturn in manufacturing.
A growth inflection point
While a mild recovery in growth is our economic base case, betting everything on a manufacturing inflection point misses a few important caveats. Firstly, while we expect a modest recovery, it isn’t certain, and could easily be derailed by a continued escalation in US–China tensions (among other factors). If growth does not inflect – and soon – downside risks re-emerge, and the probability of a global recession rises. Secondly, if growth does inflect, it is likely the inflection will be much milder than in past mid-cycle slowdowns. Thirdly, valuations are much more expensive today than in a typical mid-cycle slowdown, across both equities and credit assets. Valuations got a boost in the last few ‘mid-cycle’ manufacturing troughs – 2012 and 2016 – from a significant expansion in central bank balance sheets and major China stimulus. Neither of these are on the cards for 2020.
If global growth accelerates next year, history suggests that bond yields will rise. Looking further out, the extent to which bond yields increase over the longer term depends on whether inflation eventually stages a comeback. Right now, inflation looks well contained. There is a big difference between wanting to engineer higher inflation and being able to do so. This has been a big challenge for central banks over the last decade.
Australia set to join the QE club
Despite hopes that Australia might be different, 2019 was the year when Australia moved into the ‘lower for longer’ cash rate story. After cutting the cash rate to a low of 0.75%, it is time now for the RBA to assess the full impact of these rate cuts to the broader economy. There is clear evidence that the rate cuts are flowing into the housing market, but few signs this recovery is spreading beyond it. The RBA is still hopeful that fiscal policy decision makers become more convinced that fiscal easing is worthy of consideration.
The RBA is likely to exhaust the conventional monetary policy channel before exploring unconventional policy in the form of quantitative easing (QE). In a recent speech, the RBA Governor Phil Lowe indicated the purchase of government bonds would become an option only at a cash rate of 0.25%, indicating the effective lower bound for the cash rate is 0.25%. A pause in the easing cycle is likely to be temporary given growth is below trend, inflation is below target and the unemployment rate is rising. This view leaves us expecting further stimulus by the RBA with cuts in the cash rate, and with a move to QE a real prospect in the second half of 2020.
Our portfolio position
For most of this year, the portfolio has been structured for long duration versus benchmark, with a cautious view on lower quality credit, as we saw downside risks to the economic outlook pushing yields lower and risky assets vulnerable to slowing earnings growth. With central banks having eased policy, yields having fallen considerably from the highs of last year and with some fading of US–China trade tensions, we now see the growth outlook as more balanced. This has led to a significant change in positioning to a more neutral view. With the timing and magnitude of a growth rebound looking very uncertain we believe markets will be range-bound into the end of the year. A less directional yield environment has seen us take on several country-relative positions: longs in Australia, US and Canada – where our view is that further easing will be delivered – against shorts in the UK and Europe, where monetary policy looks largely exhausted (particularly in the latter) and where there is potential for fiscal easing to be priced into markets. We continue to hold longer-term inflation linked bonds in both the US and Australia, as inflation is under-priced in these markets.
With global growth looking to be stabilising here and central banks on hold for some time, this suggests the credit cycle has further to run. But late cycle risks remain – credit fundamentals are challenged after years of increasing leverage and slowing earnings growth. In high yield, weakness in CCC rated credit is already working its way up the credit spectrum. This could continue into 2020 if earnings growth continues to falter, threatening to push default rates higher and placing material pressure on spreads. Furthermore, valuations look unappealing with little compensation for taking on additional credit risk. This view leaves us biased towards holding high quality credit to earn carry. We favour Australian investment grade credit – including both corporate bonds and AAA-rated residential mortgages. We continue to avoid global high yield credit which is most vulnerable to earnings disappointment and an increase in defaults.
We’ve also been seeking ways to maintain yield, diversify exposures and efficiently manage risk. This is a challenge as there are few pockets of value left; however, volatility does create opportunity. After such strong market returns in 2019, the portfolio stands ready to navigate what appears to be a more challenging economic, political and market environment ahead.
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