Active management set to shine as defaults spike
It’s clear that the depth of the global economic downturn is large. How large, what the prospects for recovery are, and what aftershocks are left behind, are still areas of considerable uncertainty. The speed and unprecedented nature of the COVID-19 disruption highlights and exacerbates the divergence we are now seeing between reported economic data and economic reality. ‘Reopening’ is an uncertain exercise in which governments must trade-off economic gains against health costs should infection rates rise again. This uncertainty, plus likely hangovers (including unemployment rates that are unlikely to fall as quickly as they have spiked), makes us sceptical that a V-shaped recovery can be achieved.
Unprecedented policy support – both fiscal and monetary – has been delivered by policy-makers around the world to support their economies. All developed central banks have eased policy to the effective lower bound and aggressive purchase plans have been implemented to support both government and corporate bond markets. The fiscal response has also been rapid and significant. Policy makers have announced a series of quasi-fiscal measures such as loan support programs which will add to the size of fiscal stimulus.
The question here is whether governments’ responses have been adequate. For every per cent that GDP is expected to decline this year, the fiscal response should be of an equal size. In some cases, it will provide adequate support – including countries like Australia and the US, where the discretionary fiscal spend is greater than 10% of GDP. However, in some European countries the response looks to be inadequate. Needless to say, the less adequate the response, the greater the likelihood of a deeper recession and slower recovery as the supply side takes a permanent hit.
One of the legacies of this crisis is likely to be a significant rise in the ratio of debt to GDP. But it’s not yet clear in which part of the economy that debt will reside. It is unlikely to be the household sector, as the policy response has been designed to save jobs and protect income. The corporate sector is a likely candidate. If a significant wave of defaults is avoided, the corporate sector could exit this crisis with even greater leverage than when we entered. In that scenario, working off those debts could slow the strength of the recovery. Most likely governments will bear the costs of the crisis. The more proactively they assume the costs, the shallower the recession could be.
Risky assets rebound while bond markets remain cautious
Markets almost seem to be enjoying the various forms of stimulus announced by governments and central banks around the world. While governments force recession on their economies to supress the virus, markets have started to look forward to a strong recovery. With further evidence of virus containment alongside the fast and furious stimulus packages, risky assets (both equity and credit) have rebounded strongly from March. We would say this looks a little premature with the largest growth shock since wartime leaving large output gaps to close. Economies will be left with large loads of debt and double-digit unemployment rates which will constrain growth and inflation for some time. The recovery will be complex and is likely to be littered with defaults and a lot of businesses needing to restructure.
The government bond markets have always had a more pessimistic view of the world, and this time is no different. Where equities are looking for a V-shaped recovery, bond market yields have remained low – very low. With global interest rates now largely pegged at the lower bound and central banks having control of the yield curve, we have entered a low volatility environment for interest rate markets. This does pose several challenges for fixed income investors.
First, at the levels of yields we are now at, and with central banks are so actively involved in government bond markets, it does suggest reduced opportunities to earn duration return from here. Second, it means we need to be looking elsewhere to generate returns across the fixed income universe.
With spreads having widened from expensive valuations in 2019, the opportunity does look to be in credit markets, where valuations are now very attractive. However, a reliance on credit as a return driver does come with increased risk, suggesting that a somewhat modified approach is required. Ensuring our portfolios remain liquid and truly diversified is paramount, as was highlighted in the market volatility we saw in March.
Our portfolio position
We are now focused on rebalancing the portfolio to take advantage of the opportunities that have emerged. As the extent of the economic damage and the likely protracted nature of the recovery becomes clearer, we expect to continue to tilt the portfolio towards more attractive assets.
Credit assets performed strongly in April, following the strong sell-off in the prior month, as cheaper valuations, less crowded positioning and additional policy support from the US Fed and ECB all helped to boost sentiment. But we don’t believe it’s all rosy for credit markets just yet.
Central bank buying programs are unlikely to discourage rating agencies from downgrades, while policy measures to date are unlikely to avert the worst default rate cycle since 2009. Our concern is that the severity of the current contraction in economic activity, occurring after the build-up of large corporate debt and slow deterioration in other metrics of credit quality, could produce an upturn in defaults which could exceed previous cycles. This outcome is not priced into markets.
We are maintaining a preference towards higher quality investment grade over higher yielding credit, though at the end of March we did allocate towards those assets that repriced the most aggressively – global investment grade and high yield corporates – and to Australian sub debt. Australian investment grade credit is our preferred corporate exposure for its high quality in this environment. Australian mortgages remain attractive for their sound fundamentals and as a diversifier to corporate credit exposure. We also maintain our allocations to US mortgages and emerging market debt, seeking to diversify both income and risk sources. The recent allocations to credit have been funded by selling down our exposure to our government assets, although we did add selectively to semi government bonds in April as spreads in the back end of curves remain attractive.
Coming into this crisis we were overweight duration, with exposures concentrated at the front of yield curves where central banks were on the path to cutting interest rates to the zero bound. This duration position has now been moderated to a more neutral view versus the benchmark, bond yields now having reached our targets. With central banks now implementing quantitative easing (QE) we have transitioned our portfolios to the mid part of yield curves where central banks are focusing their purchases. We are concerned about the large amount of government issuance to fund fiscal spending and central banks already starting to taper their asset purchases. This is likely to lead to a steepening of curves with long end yields rising more than the front end. This keeps us modestly short in back ends of curves.
In April we reduced some of our inflation exposure, now holding a small long position in Australian inflation. Inflation remains a longer-term risk and certainly looks cheap, but our preference is to hold credit assets over inflation over the medium term.
Active managers haven’t done particularly well over the last two months, a short-term horizon. This mostly relates to the fact that there were very few fixed income assets that did well, and hedges also weren’t that effective. In general, a longer horizon is required to better assess the benefits of active management. We believe our active asset allocation approach is one that will be rewarded in this environment. The ability to access a broad opportunity set within a global capability delivers a more flexible and diversified approach to fixed income investing. It is this will, we believe, will ultimately deliver sustainable outcomes to our clients over the longer term.
It’s true that the COVID-19 crisis was a shock and different outcomes are largely driven by style. While offering defensive solutions for broader portfolios, fixed income managers are also trying to deliver on return objectives and do need to take risk to deliver on these. Over the last two months few risk exposures worked. It’s imperative to know your manager’s style, understand the risks your portfolio is exposed to, and how these integrate with your broader portfolio.
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