Fixed Income

When the future is black, or white

What the future holds for investors depends entirely on where you look for guidance. According to bond market performance, there is a risk of US recession, while the equities markets are priced on the expectation of robust growth. Only one can be right.

16/09/2019

Mihkel Kase

Mihkel Kase

Fund Manager, Fixed Income

The market outlook continues to remain challenging for investors. Central banks driving rates lower, trade wars and Brexit – among other issues – are contributing to continued uncertainty in markets. Equity, bond and credit markets appear to be pricing very different outcomes.

The bond market is warning of an impending US recession as the yield curve between the 2-year and 10-year US Treasury bonds “inverted” for the first time since 2007. With the yield curve inverting prior to every US recession since 1955, it is generally seen as one of the most reliable leading indicators of a market downturn.

The equity market, on the other hand, is expecting a healthy US economy – the consensus of analysts is for earnings growth of 8% over the next 12 months, although backing out the implied earnings growth from the market brings this number closer to 7%. For this to be achieved, the US economy must grow robustly over the next year. If the bond market is right, then valuations for US equity markets look stretched and recession-induced falls would be particularly large.

Credit markets appear to be somewhere in the middle of the two. Valuations remain tight but have not retraced to pre-GFC levels. Default rates are expected to stay low and, in the absence of recession, credit should continue to provide carry for investors. That said, we would expect bouts of volatility as markets adjust to changes in sentiment. The credit market does remain well supported. For example, in the past week there has been USD$74bn of issuance in the US investment grade market at historically low yields. Some may argue that corporates are concerned their access to cheap and easy funding may disappear and they are sourcing funding before markets seize up, but an alternate view is they are putting in place the capital to fund the next wave of expansion. Time will tell, but at least in the short term credit markets are functioning and the threat of defaults appears low based on market pricing.  

The question is how can investors navigate through this period, particularly those looking for income without taking excessive risks. Given the ongoing uncertainties and apparent imbalances in the market, our approach has been to remain defensive in our risk allocations, maintaining a long duration position while also ensuring the portfolio is well diversified and liquid. Importantly, we continue to believe it’s important to be active to adjust to market changes and balance the risk and return trade off in the portfolio.

As such, we retain a core portfolio of high quality investment grade credit that is diversified by geography, sector, quality and capital structure. We are avoiding the leveraged loan market, and are net short the global high yield market given valuations and our preference for quality. Investment grade credit provides a source of return but importantly has a low probability of default and low capital risk. Our credit positioning is supplemented with our exposure to our Schroder Emerging Market Debt Absolute Return portfolio that adds diversification and exposure to local and hard currency emerging market sovereigns.

During the month we increased duration by 0.65 years to around 2.5years in total, based on the view that the rally in government bonds would continue. The duration position continues to provide term premium and importantly, protection against risk-off events. Our key exposures are in Australia and the US where yields remain positive, and we also have a small long position in Germany. We have a small inflation-linked position that serves more as a downside risk exposure, which will be a benefit to the portfolio in the case of an inflation scare.

We continue to hold currency exposure to the USD and Japanese Yen to add further downside protection in a risk-off environment, combined with an elevated cash level to provide liquidity, capital stability, and the ability to quickly take advantage of opportunities. Overall, by design, we have a diversified defensive multi-strategy portfolio that actively manages across credit, rates and currency to deliver regular predicable monthly income.

The portfolio is delivering on its targets and we are not looking to increase risk to chase yield at this stage of the cycle. We remain focused on delivering income, managing capital volatility and being patient and alert to both opportunity and risks, and await asset repricing before looking to reposition portfolio in a more constructive way. 

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