Moving through the transition


As we move through quarter end and financial year end it is clear the challenges of  COVID-19 persist. Vaccine rollouts have begun at different rates around the globe but will take time to complete. COVID-19 cases globally have exceeded 183 million with close to 4 million deaths reported, underscoring the ongoing humanitarian impact. Australia has been less impacted than many countries, although at quarter end we have seen a return to lockdown in many parts of Australia to manage a rise in cases of the Delta strain.

Despite the ongoing COVID situation, risk assets have remained buoyant. Central banks have continued to provide stimulus, global growth looks more robust and the threat of inflation is seen as transitory at this stage. This confluence of factors has resulted in risk assets remaining well supported and credit markets focusing on the positive corporate earnings outlook and low default rates. At the same time, quantitative easing (QE) through central bank bond-buying programs has kept bond yields somewhat anchored and volatility low.

The future path is one where, arguably, the extremely accommodative posture of the central banks will be unwound. The large amount of liquidity in the system and the emergency policy settings do have a use-by date and the aim will be a normalisation of policy at some point. Central banks have started telegraphing the fact that a reduction in the level of stimulus will begin and timelines are being introduced softly into the market to avoid a panic. For example, post quarter end the RBA has indicated it will take the first steps to dial back stimulus. Whilst official interest rates were unchanged at the recent RBA meeting, the QE program will be reduced in response to the improving economy. Small, incremental steps are also occurring in other economies.

Whilst we don’t foresee an imminent repricing of risks, we also believe that the steps being taken currently by central banks have the potential to unsettle markets at some point. This combined with the risk of inflation moving from transitory in nature to more structural serve to narrow the margin of error.

This is against the backdrop of extended market valuations where most risk assets are fairly fully priced and future return expectations are subdued as a result. Whilst the current shorter-term optimistic outlook is to some extent warranted it is important that investors don’t become complacent.

For investors, the task of generating income remains a challenge. Even if cash rates do begin to rise, the starting point of cash rates and term deposits at (or close to) zero means holding cash will be difficult.

Credit continues to be a source of return, although we believe we are in a carry phase with limited room for yield compression moving forward. Credit spreads have largely been undisturbed by the rise in bond yields as markets focus on growth and positive earnings trajectories. The low levels of defaults also highlight  lower capital downside risk but caution is warranted.

How we’re positioned

In terms of portfolio positioning we have made a few adjustments to the credit exposures. In Australia, we adjusted the credit mix by reducing exposures to Residential Mortgage Backed Securities (RMBS) and Australian investment grade credit by 1% each and added 2% into higher yielding credit, including hybrids. This was designed to increase the yield of the portfolio and take advantage of the credit sectors that have greater ability to see further spread compression. We still see value in asset classes like US securitised debt, emerging market debt and Asian credit. We also added 1% to global investment grade credit out of cash. We have also retained our global high yield exposure. This provides a yield boost to the portfolio, but the higher potential volatility means our exposure is currently limited at current valuation levels.

In terms of rates, we added a short US inflation-linked bond position to take advantage of some mispricing on the inflation curve. We sold 0.25 years of inflation at the 5 year maturity (which, on our view, appears to be elevated) which should contribute to the portfolio should we see medium term inflation expectations fade. Overall, the portfolio continues to have low sensitivity to interest rates. The low level of duration aims to ensure the portfolio will be insulated should bond yields rise as central banks continue with their incremental withdrawal of liquidity.

In terms of foreign currency, our exposures are in the middle of recent ranges with USD and Japanese yen (JPY) exposure aimed to assist the portfolio in the case of a risk-off event in markets.

We are conscious that as we move through this transition phase that volatility is likely to rise. The starting point of market valuations and the sensitivity of bonds and risk assets to the move higher in interest rates is one to watch carefully. Overall, the portfolio remains defensive with an average investment grade credit rating; we are carrying low interest rate sensitivity, and our currency positions are moderate. We remain liquid but importantly active and alert to opportunities as markets move forward.

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