US end-cycle continues to dominate strategy
In our last report we noted that an obvious circuit-breaker to the market turmoil of the December quarter would be a more dovish central bank shift. This was delivered in commentary by Fed chair Powell in the early part of January and reaffirmed at the FOMC’s late month meeting. Alongside this, we considered that both the US/global growth deceleration apparent in recent months and the unlikeliness of a material near-term reacceleration should see rates somewhat rangebound, but that credit offered a relatively appealing opportunity after recent weakness.
The post-GFC economic cycle has been more muted than previously, and therefore more dependent on policy for marginal change. In turn markets have become heavily dependent on policy, both because of the higher economic dependency on policy, as well as because of the direct implementation of policy via markets (eg central banks buying bonds). The bounce in market sentiment that has occurred year-to-date is therefore unsurprising, but now that the dovish shift has been delivered, and markets have recovered some of their nerve, the question is: “what now?”
Firstly, valuations of riskier assets, having moved closer to fair during December, are now back in expensive territory. To some degree a more dovish central bank environment supports this – the pace of stimulus withdrawal slows, policy certainty increases, market volatility falls.
Secondly, it’s too early to declare the economic cycle over. While late last year markets shifted from worrying about higher inflation to worrying about lower growth, actually we think they should be worrying about both – with respect to the US at least, we think we are in the late stage of the cycle where both inflation rises and growth slows, a generally unfavourable cocktail for markets. Although we have downshifted our view on both US growth and inflation over the past six months, we still see the US economy travelling through this late stage for some time – our models are still saying recession is more than 12 months away – and perhaps the Fed pause can allow the US cycle to extend. Alongside this, corporate fundamentals are weakening, but not yet especially problematic.
Beyond the US, the global economy has been weakening for some time. It’s clear that China’s slowdown has been a key driver – stronger policy stimulus and an easing of the trade war appear required to arrest this. Locally, the ongoing housing correction, concern around global developments, and persistent low inflation have seen the RBA join the dovish chorus this week.
Thirdly, it would seem that the bounce in market sentiment needs to be validated by an improvement in economic data to be sustained. We think the downward trends in global manufacturing and trade data will take some time to arrest so don’t expect this to occur in the near term.
We bought about a year of duration in the December quarter. This leaves us a little overweight Australian interest rate risk, neutral in the US and short in Europe, where value remains poorest. In addition to the country positions we have largely kept in place both yield curve flatteners and inflation linked exposures, and look for moderate repricing in each. While our expectation is for a range trading rates environment in the near term, we expect to be adding considerably more duration to the portfolio on opportunity through 2019, as the US economic cycle ages further.
We’re happy to hold higher quality credit for carry, and although we might add on near-term weakness, we are not expecting to build up a very significant credit holding at this point given the stage of the US cycle. Our preference remains for Australian investment grade corporates, and against global high yield. Although we added a little exposure to each during the Q4 weakness, our most recent changes have been to add Australian IG but reduce US HY. We retain an effective short position in the latter.
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