Turning off the tap
The global theme of central banks removing stimulus continued in July with Bank of Canada raising interest rates while European Central Bank commentary suggests that the risks to growth are now broadly balanced (and no longer deflationary). We expect the global economy to continue its cyclical recovery as we move into the second half of 2017, predominantly in the US, but also in Europe and across the globe. As a result, the global output gap will continue to gradually close.
The market continues to focus on the lack of inflationary pressure in most parts of the world, and it is particularly puzzling in those advanced economies where labour markets are now tight. In the shorter term, the market has become excessively downbeat on the near term, cyclical US inflation outlook. Despite structural factors such as demographics and technology continuing to place downward pressure on inflation in the long term, recent weakness in the dollar together with continued job gains supporting a gradual build-up of wage pressures, should lead to a progressive rise in US inflation over the next 6 months. A move higher in US inflation should see the market re-price future Fed rate hikes over the next 12 months, which are currently under-priced.
Locally the market is focussed on the Reserve Bank of Australia, which created a flurry by stating that it believes that the ‘neutral’ official rate is around 3.5%. With the cash rate now at 1.5%, the market interpreted the minutes as ‘hawkish’ which sent the AUD above $US0.80, on the increased expectation of a RBA rate rise. However, the RBA is likely to be on hold for the foreseeable future. Low underlying inflation suggests an accommodative policy setting is appropriate, while the rise in the AUD is acting as an additional constraint on early action by the RBA. Having said this, the balance of risks has shifted notably over the past month or so. The high level of business conditions, the related strength of the labour market, the recent gains in consumer confidence and the ever so gradual creep higher in core inflation suggest the prospect of a RBA rate hike in 2018 is rising.
Looking ahead, there is significant global monetary policy uncertainty looming on the horizon. Investors need to be alert to shifting policies as we move into a different phase of the global cycle with less accommodative policy and reduced QE. In September, the US Federal Reserve (Fed) is expected to announce plans for a gradual reduction of its $4.5 trillion balance sheet. In addition, the ECB are currently planning how they will slowly wind down their asset purchase programme over the next 18 months, while the Bank of Japan are now buying fewer JGBs as a result of yield curve control. It therefore appears that we are finally past the point of ‘peak flow’ of central bank liquidity into the global economy. Our base case is that the Fed manages the announcement and execution of balance sheet run-down fairly smoothly, thanks to emphasis on a very gradual pace of unwind. We must, however, acknowledge the possibility of unintended consequences. For example, we believe there could be a higher likelihood of periodic “tantrum” type episodes in markets, particularly in those asset classes which have been the biggest beneficiaries of repeated waves of central bank liquidity over the last nine years, and where compensation for taking risk is now very asymmetric.
Having said this, we do not believe we are facing a bear market in risk assets: while inflation remains benign around the world, there is limited justification for central bankers to become aggressive. Nevertheless, as a result of the expected increase in asset price volatility over the next year or two, we believe that an emphasis on defensive portfolio construction is more important than ever. We remain focused on value – this means staying short duration relative to benchmark and holding a very modest credit position – as both interest rate and credit risk is expensive. We have retained 15% exposure to cash to allow for some ‘dry powder’ to buy into any market tantrums that clear out heavy investor positioning and improve valuations across asset classes.
Our short duration position (currently totalling 0.7 years) is concentrated in Europe, where valuations – reflecting ECB intervention - are most extreme. While all developed bond markets remain expensive on our measures, in general our preference is to be short the low yielding (most expensive markets) in favour of owning the higher yielding (less expensive markets). More tactically, with the recent outperformance of the US, we believe there is scope for US yields to rise further than Australia into the end of the year and have taken the opportunity to add a spread narrower trade. We are also still biased for some yield curve steepening with term premia remaining relatively depressed. Given our view that it is inflation that is likely to be the catalyst (if there is one) which causes us to break out of the current yield-chasing regime, being long inflation-linked bonds (mainly in Australia) remains a cheap hedge.
With an improvement in the global growth outlook, little inflationary pressure and ongoing stimulatory monetary policy risk assets continue to perform well. While investment grade credit markets are tight, they have been tighter at the peak of past bull markets. However, this does not mean that credit is ‘cheaper’ today, adjusting for compositional differences. Global credit indices are much lower rated today and have longer duration. Yields are also lower and prices are higher compared to history. This means we should be getting more compensation to account for these differences in the market over time. This by no means implies that spreads cannot tighten further. Valuations will not be the determinant of what ends this cycle. But it does tell us that the risks around returns in credit assets are rising. Our focus remains one of avoidance of downside risk. Our credit allocations are modest (at benchmark weight), having steadily pared exposures over the prior year as spreads have compressed. Our preference remains for short duration high quality Australian debt over longer and lower quality global exposures, and subordinated domestic issues.
Our defensive portfolio positioning is a function of reduced opportunities within the “Core Plus” universe. Quantitative easing has altered the face of markets by underpinning strong returns and lowering volatility, leaving most assets rich and with higher forward-looking risk. An unwind of QE should see some retracement. We are alert to these shifting policies and look for an opportunity to reinvest in markets. In the meantime, we are focussed on valuations and delivering defensive outcomes.
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