Fixed income shines in turbulent times

For some time now, we have been concerned about extended valuations in risky markets, but unsure of the catalyst for a major repricing. February brought just this catalyst, with coronavirus fears leading to a sharp fall in both equity prices and bond yields.

The speed of the decline in bond yields has been nothing short of stunning and has provided investors with strong returns (even at low yields). High-quality fixed income is once again proving to be a great hedge against equity risk, over short term timeframes in most circumstances.  

The rest of the world was slow to recognise the danger coronavirus posed beyond China. As well as the tragic human impact, the economic disruption is likely to be intense, with both supply and demand curtailed. The outbreak of the virus has stopped the global recovery in its tracks. Business surveys suggest global growth will be very weak in Q1, with a contraction possible.

Racing towards the zero lower bound

Faced with this huge shock, central banks are back easing policy, with the US Federal Reserve implementing the first inter-meeting 50bps cut since the GFC in early March. The primary question for markets is whether the coordinated unleashing of global monetary accommodation is decisive in reversing the sharp downside risks that are being priced into markets – the historical evidence and details of the current risks are not encouraging.

We are in unchartered territory, as the current threat to the global cycle is not a phenomenon of financial nature (as it was in the 2007/08 episodes). US Fed Chair Powell himself acknowledged this in a recent press conference, stating that “we do recognise a rate cut will not reduce the rate of infection and won’t fix a broken supply chain.”

It is no secret that the US has more room to cut than other central banks. A return to the zero lower bound must now be considered among the Fed’s appropriate policy responses to the outbreak. This raises some concern, as the scope for central banks to cut rates is limited, and rate cuts are not necessarily the right policy response to what’s happening now. Governments struggling to contain the global economic fallout from the coronavirus outbreak face mounting calls to unleash a major fiscal stimulus that could help cushion the blow. To be effective, such fiscal support needs to be targeted to provide cashflow relief for companies in order to limit bankruptcies.

Australia is one of the most exposed countries to weaker Chinese demand. The RBA, in cutting the cash rate in early March to 0.5%, clearly felt that the growing risk to the Australian outlook warranted decisive and early action. This all comes at a time when the backdrop for Australia is one of weak growth, low inflation and lack of momentum in the jobs market. A fiscal response has become more likely but could be very underwhelming. We expect the RBA to take the cash rate lower to the effective lower bound and most likely implement QE.

Our portfolio position

We entered February with duration longer than benchmark by about 0.50 years, but increased this materially to be 1.20 years long at the time of writing. Our preferred exposure is in US Treasuries, both because the Fed can ease by more than other central banks, and because Treasuries are a safe haven in uncertain times. We also have small long positions in Australia and Canada. We continue to hold inflation linked bonds on valuation grounds, although these are likely to continue underperforming in the near term with the collapse in oil prices.

For credit, the cashflow shock has clear negative implications for corporate profitability and is likely to increase the risk of financial distress for the low end of the quality spectrum. We remain short global high yield. We predominantly hold high-quality Australian investment grade credit, but have pared back our exposure considerably. Australian mortgages remain attractive, both on relative valuation to corporates 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.

Overall, the portfolio retains it long duration and high-quality focus, placing a priority on preserving liquidity, meaning we are well-placed to weather these turbulent times.

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