Fixed Income

Adjusting expectations as reality bites

They say optimists live longer – but what about their investments? Although a US recession still seems some time away, and trade tensions have been lessening, there are still good reasons for investors to consider a defensive posture while re-examining their return expectations.

16/10/2019

Mihkel Kase

Mihkel Kase

Fund Manager, Fixed Income

Schroders has recently published the results of our most recent Global Investor Survey, which explores the behaviours and attitudes of more than 25,000 people who invest across 32 locations around the world.  The top three factors for people were, in order: avoiding losing money, meeting total return expectations, and generating an expected level of income. The Global Investor Survey also revealed that people still expect to earn 10.7% on their investment portfolio over the next five years, and for Australian investors this number was higher still. From where we sit, these expectations appear in need of downwards adjustment to reflect the reality of a low yield, low growth, low return world.

Downside risks remain, despite monetary easing

Why do we think investors need to adjust their expectations? Because we still see considerable downside risks to the global economy, despite widespread central bank easing and recent signs that the icy US–China trade relationship may be about to thaw. One reason for caution is the lack of uniformity in policy stimulus – while the ECB and the RBA have eased considerably, they have yet to receive the fiscal policy support they have sought. In the US, the Fed has resisted anything beyond ‘insurance’ cuts, while easing by the PBoC seems to have been limited by a desire to avoid reflating the Chinese property sector. There are also some indications that US policy may be too tight, with turbulence in the US repo market suggesting that liquidity is unable to move quickly, or quickly enough.

Whether there is anything more sinister under the surface remains to be seen. Yet downside risks are likely to continue to dominate markets regardless, with the impact of both tariffs and tight US policy (relative to the rest of the world) already priced in. To date, the fallout has mainly been in global manufacturing and trade, but there is a clear risk that it spreads to services, where the bulk of jobs in the developed economies reside. That fallout could potentially be countered by proactive policy shifts, but so far there are no signs of those.

How large is any economic slowdown likely to be – and how concerned should we be about riskier assets? A large part of the answer depends on the timing of the next US recession. We’ve been watching the indicators closely and still believe that any recession is some distance away. Yet that distance may be shortening, with activity expected to slow further in the near term. That suggests investor caution is warranted, with riskier assets fairly fully valued on the back of what may prove to be markedly optimistic earnings expectations. Again, only time will tell.

Our portfolio position

Given the concerns on riskier assets and the reality of a low yield, low growth, low return world, we remain defensive in our risk allocations, maintaining a long duration position while also ensuring the portfolio is high quality, well diversified and liquid. We continue to believe it is important to be active to adjust to market changes and balance the risk and return trade-off in the portfolio.

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

During the quarter we reduced duration to 1.5 years down from a peak of around 2.5 years earlier in the year. Given the extent of the rally and the outright levels we trimmed our duration. Our key exposures remain in Australia and the US where yields remain positive. We removed the small long position in Germany. We have a small inflation linked position which 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. 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 while managing capital volatility. We are patient but alert to both opportunity and risks, and await asset repricing before looking to reposition the portfolio in a more constructive way. 

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