Fixed income remains in a holding pattern


Compared to the second half of last year, the portfolio’s current risk settings are cautious. Exposure to further increases in interest rates is lower than the benchmark and we have substantially reduced the portfolio’s credit exposure. We’re expecting the strong global recovery to continue to pressure yields higher, although a good portion of this repricing has probably already occurred. Credit securities remain well supported by the improvement in the economic cycle but valuations are extended, with the yield premium offered relative to risk government securities low. We’re expecting higher volatility in interest rates, linked to firming inflation data, to provide us with the opportunity to reposition the portfolio with more interest rate duration and credit exposure.

Calm before the storm?

The relative calm in bond markets during the last two months belies an underlying tension between a robust global recovery and extraordinary fiscal policy support. The medically-induced cycle and the massive policy response have been different in so many ways to previous experiences, meaning there is greater uncertainty about how each will evolve from this point.

It’s highly likely that this year will be exceptionally strong for global growth. Leading the charge, but not alone, the US is expected to post a Q2 annualised growth rate of 10%, with 6% growth estimated for the full year. By the end of 2021, the US will have more than fully recovered all the economic activity lost during 2020, quite an astounding feat considering it took more than five years for the same to occur following the GFC. The very sizeable income support programs and an absence of systemic banking issues are key differences this time around.

In responding to the COVID-19 crisis, policymakers were keen to apply the lessons learnt from the GFC – that is, go early and go hard. This has worked out nicely. Central Banks now seem keen to apply the lessons learnt from the policy withdrawal stage – namely, delay and do it softly.  However, given the much stronger recovery, a pre-commitment to super-accommodative policy for several more years, based on the GFC experience, might be an over-reaction this time around.

Bond markets reacted earlier this year to the better-than-expected recovery, alongside the positive news of rapid vaccine rollouts (at least outside Australia!) and the upscaled government spending in the US following Biden’s election. From historic lows, sovereign bond yields jumped, particularly in February. However, despite signs almost everywhere of accelerating activity and lifting inflation, bonds marked time through March and April. This was mostly due to the already high expectations and associated consensus positioning for higher yields, as well as continued dovish commentary from central bankers. Meanwhile, riskier assets have powered on, high yield credit spreads are historically tight, and equities are reaching new peaks.

This leaves fixed income at somewhat of an inflection point. At these higher yields, income levels are being restored, and bonds become more attractive as diversifiers. Relative value between different bond markets is also appearing, aided by reduced hedging costs and steeper yield curves. Our view is that fixed income is undergoing a healthy transition, and in the process, it is becoming more valuable. As a result, we are aiming to get more constructively positioned in our portfolios, though for now we will wait patiently until better opportunities present themselves.

Some observers are drawing parallels between the current environment and 2013. For one aspect, US Treasury yields are at about the same levels as prior to the “taper tantrum” in 2013. However, expecting a repeat is all too simplistic. Heightened expectations for a certain outcome usually diminish the likelihood of the outcome occurring. Like consensus opinion, we maintain an upbeat view of the cycle, while attempting to unpick where the meaningful differences, and hence opportunities, may lie.

A critical issue is the evolution of inflation and how the central banks will respond to it. Inflation is lifting much more meaningfully at this stage of the cycle than is usual, both because of the stronger demand rebound and supply bottlenecks. Meanwhile, central banks have committed to look past a cyclical overshoot in inflation and not raise rates until it is back above target. The lack of clarity between these two commitments suggests that as inflation overshoots, the markets will become increasingly concerned that central banks might respond by lifting rates. This would see nominal bond yields rise further, driven by a rise in real yields.

How we’re positioned

Consequently, we’re running short duration compared to benchmark, concentrating this underweight at the short to intermediate part of the yield curve, and we have reduced our inflation-linked exposure. Given the rise in yields already seen, we’ve also moderated our overall underweight duration position as compared to earlier in the year.

Country divergence potentially creates another opportunity. Beyond the market focus on US yields, Chinese and other Asian bond yields repriced higher late last year as economies reopened earlier, while European yields lagged as economic reopening was delayed. Further divergence relating to the pace and nature of central bank policy withdrawal is also likely. We’ve reduced the size of our short duration position in the US and repositioned some of this into Europe and the UK, while closely monitoring the impact of rising US rates on emerging markets.

Credit fundamentals continue to improve as earnings recover, with many asset spreads back to post-GFC lows. Respecting the negative valuation signal, we’ve made meaningful strategic reductions in credit exposure over the past months, primarily in global investment grade credit, but also in Australian investment grade bonds and mortgages.

In expectation of an increase in market volatility and uncertainty about the central bank response to much stronger data, we have taken a tactical short position in US high yield credit. Apart from these deallocations, we remain moderately constructive on credit assets and expect the search for yield to continue in an improving macroeconomic environment. A diversified credit exposure also adds further balance to the portfolio alongside the mix of sovereign and rates exposures.

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