The calm after the chaos?
The calm after the chaos?
2020 saw once-in-a century swings in the economy, policy and markets. After that year of chaos, maybe 2021 will be refreshingly normal! Though challenges remain, we think the global recovery remains on a solid footing, strongly supported by policy makers across the globe. In our view, it will be another year of fiscal expansion alongside very accommodative monetary policy, with low yields driving the search for returns.
Since mid-November, bond yields have been rising on the back of the US election and the announcement of several very effective vaccines. As we expected, this move continued in January, helped by the Democratic sweep after the senate elections in early January.
The yield move has been reasonably muted – about 30bps since early November, driven by policy and vaccine optimism. We expect that stronger economic data will confirm this optimism and drive the next leg of yields higher in the coming months.
Reflation, central banks and growth assets
One reason why reflation trades have worked well is because central banks have managed to keep government bond yields (and real yields) from rising sharply. Their yield curve control has been highly effective, keeping shorter-dated securities pinned near the cash rate and allowing for limited yield increases for longer-dated securities.
Central banks would prefer a gradual rise in yields to lower the risk of them falling too far behind fundamentals and resulting in the quantitative easing ‘taper tantrum’ that destabilised markets in 2013. We believe central banks, in particular the US Federal Reserve, understand that risk, and will prevent a replay of the dramatic tightening in financial conditions, as they eventually scale back on their quantitative easing program.
The more notable performance from the reflation trade has so far come from growth assets, which, buoyed by the expectation of economic recovery amid ongoing policy support, are in most cases now back to spread levels from 12 months ago. This leaves investors navigating a delicate balance. Companies went into survival mode in 2020, reducing costs and ensuring access to liquidity to stabilise their balance sheets, often by taking on more debt. Recovering from a weak position, fundamentals are now improving as profitability recovers. However, valuations on corporate bonds are no longer cheap as yields have compressed significantly and are now arguably expensive.
Nevertheless, we still believe credit allocations will deliver the best returns in the fixed income universe for some time yet. But this outlook is not without risks – particularly in the short term.
Market sectors that have excessive optimism priced in warrant caution. We are carefully participating in the ongoing recovery with selective allocations to asset classes like Asian credit and emerging market debt, which are still attractive. This is alongside broader portfolio positioning for higher yields and more volatility.
Our portfolio position
Our main focus is security selection within our allocations. We are making sure we are positioned in issuers and sectors like transport and property trusts that have lagged the broader recovery, and which will further benefit as the economy reopens. While global investment grade credit has performed extremely well, we have reduced our exposure to this asset class. That’s because valuations are expensive – and this sector is vulnerable to a move higher in yields, with higher interest-rate sensitivity compared to other credit markets.
The reflation trade has also seen inflation-risk premia hitting multi-year highs, with breakeven inflation rates – a proxy for the market’s expected future inflation rate – having moved up sharply and more than reversed their 2020 fall. This increase reflects a dissipation in the perceived downside risks to the inflation outlook, amid a broad-based improvement in global economic prospects.
We believe the risks to the inflation outlook is tilted to the upside. That’s why we’ve rotated some of our strongly-performing credit exposures and invested into inflation-linked bonds which pay a semi-annual coupon that adjusts with the inflation rate, both in the US and in Australia.
Guarding against rate volatility
As well as increasing the portfolio’s exposure to higher inflation, we have been preparing it for higher interest-rate volatility. We continue to see yields on longer-dated securities moving gradually higher under an implicit yield curve control framework administered by the central banks. In response, we have been reducing our duration across global interest rate markets, particularly in US treasuries and in Europe, UK and Canada.
Australia remains our preferred market, with the Reserve Bank of Australia (RBA) remaining extraordinarily accommodative, announcing an extension of their quantitative easing program in February. While the RBA will hold yields lower for longer, with global and local data improving rapidly this won’t prevent the market from pricing in a higher probability of interest rate increases in future.
With yields low, we need to work harder to deliver returns. However, there is plenty of scope for quality income generation across a broad global opportunity set. We are keeping portfolios well diversified, remaining flexible to capture opportunities and manage risk. After delivering our investors a strong performance in 2020, we believe we will continue to deliver returns in a more subdued 2021.
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