Reflation trades dominate as positivity grows


Accommodative monetary conditions, large, ongoing fiscal stimulus, the US election finally over and vaccine rollouts beginning: 2021 has opened against a backdrop of positive news. These events continue to support the reflation trade, currently boosting market sentiment. Demand is also being driven by investors in search for yield-based assets in credit markets, which is presenting a positive technical backdrop.

The improved growth outlook is expected to continue, with bond yields drifting higher. While the extent of their move is potentially contained by central banks’ quantitative easing programs and their desire to keep rates ‘lower for longer’, higher bond yields remain a possibility and present a risk to assets with duration exposure.

The challenge for investors seeking low-risk income is further highlighted in Australia, where the Reserve Bank of Australia (RBA) announced it planned to keep the cash rate unchanged for the next three years. This decision aims to remove potential uncertainty, but clearly signals the challenges remain for investors seeking income as cash rates remain anchored close to zero.

Looking forward, the risk of inflation in increasingly occupying investors’ minds. Central banks have been attempting to generate inflation for some time, but haven’t done so yet.  However, inflation expectations are now picking up. Inflation risk premia have hit multi-year highs, and breakeven inflation rates (the market proxy for inflation expectations) having increased sharply in the past months and have now fully reversed the 2020 dip. In our view, risks to the inflation outlook view are tilted to the upside. So while we already have some inflation protection, we are considering increasing this further.

Our portfolio position

Because we believe credit markets are a key source of income, we think a wholesale rotation out of credit assets is not warranted. With credit assets supported by both the current positive fiscal and monetary backdrop and the demand for yield-based assets, we have made no material changes to portfolio positioning. But that’s not to say that risks are non-existent. We stand ready to reduce our exposure to credit securities if yield spreads continue to compress tighter.

In offshore markets, we retained our tactical exposure to global high yield at 3% of the portfolio – one of the highest available yields compared to cash. The global high-yield market is mostly US-domestically focused and continues to benefit from its government’s fiscal support. It is also shorter in duration than many investment-grade markets. This means unlike longer-dated maturities, it has less exposure to steepening credit curves and increasing interest rates.

We have retained our US investment-grade holdings but are looking to reduce the exposure as the duration of the market continues to increase. A large amount of supply has been absorbed by investors and any softening in demand would likely see spreads widen. We have increased our US securitised credit exposures by moving part of our Australian exposure to the US. These US exposures continue to be defensive, highly rated and typically senior in the capital structure, while also delivering income from a variety of sub-asset sectors.

Asian credit exposures continue to provide the portfolio with more yield and diversification compared to the domestic market. With a yield marginally less than the US high-yield market, they provide an attractive yield over cash for a lower credit risk.

We continue to hold exposures to the  Schroder ISF Global Income Short Duration Fund which in turn is exposed predominantly to European credit. While it does provides diversification to the US holdings, crucially, it’s shorter in duration and is likely to be less variable if there is a spike in volatility. Our emerging market debt exposures also aim to capture value in hard currency (mostly US-dollar denominated) and local currency bonds in these markets, but with a disciplined, downside risk-managed approach rather than a benchmark exposure.

Australian fixed income

In the Australian market, we remain exposed to Australian investment-grade credit. We have shifted to sectors that lagged the initial rally to take advantage of their likely recovery. For example, we have reduced our bank holdings and increased exposure to debt from infrastructure companies.

Our hybrid exposures continue to provide a subordination risk premium and a strong income source income to the portfolio. Australian residential mortgage-backed securities continue to provide a cash-like exposure although these exposures continue to pay down principal – the proceeds of which we are putting into other assets offshore.

Our duration exposures remain predominantly split between Australia and the US. We have been reducing our interest-rate exposure duration –  down to 1.15 years at month end, compared to close to 2.2 years in November last year – as we were concerned that yields were moving higher. While we still believe duration plays a role in portfolios, its effectiveness is somewhat limited. We continue to assess our overall exposure, where it is positioned on the yield curve and how best to achieve some downside risk protection in a more extreme risk-off scenario.

Currency

We previously reduced our USD position to around 1.5% from a peak of 8% during the March quarter of 2020, switching to Japanese yen as our preferred foreign currency to capture some downside risk protection. The USD has weakened sharply since we reduced our position, so we are shifting our defensive currency positions back towards a long USD exposure.

Overall, we remain liquid, active and diversified – but with a defensive bias appropriate to deliver an income stream from the fixed-income position of a client’s portfolio. As risk assets continue to perform well, we expect to continue to reduce allocations. We are also closely monitoring the current inflation regime for any potential for change.

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