Fixed Income

Markets roar back, but it’s not over yet

Stuart Dear

Stuart Dear

Deputy Head of Fixed Income

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At the time of writing, US stock markets are up almost 45% since the March lows, which is easily the biggest move up in the shortest time ever. Markets are rallying hard as a number of positive drivers appear to have come together: a fast and sizeable policy response, the containment of the medical emergency in many western economies, and early data suggesting the rebound in activity might be sharper than initially feared.

Back in March, with cash rates at zero and credit spreads at their widest, we identified that the best opportunities in fixed income were in credit. This was reinforced by the actions of central banks. By moving to control the yield curve, central banks limited the active opportunity in rates, while at the same time the provision of solvency support and direct market purchases reduced downside potential in credit.

As a result, we positioned our portfolios to capture this rebound, although we have been surprised by its speed. Short positioning by fund managers in risky assets appears to have been part of the cause – caught on the wrong side, managers have had to painfully cover, or even chase returns in unloved places (such as value equities or high yield credit, which lagged the early part of the rally).

It’s just a recession, after all

It’s a funny thing to say, but markets seem to be cheering the fact that the COVID-19 crisis looks likely to deliver ‘only a recession’, rather than the depression many were fearing. Fundamentally things still look pretty bad – unemployment rates are in double digits in the US and Europe, earnings have slumped and dividends have been cut, defaults are rising, business and consumer sentiment is poor, and inflation is weak. However, at least in the short term, the marginal change matters a lot for markets and things are looking better than they were a month ago. In addition, markets seem very confident that central bankers have (once again) minimised many of the risks.

However, the uncertainty in evaluating the current environment is considerable: it’s a medical emergency that is both new to health specialists and for which there is still no effective vaccine; policymakers, business leaders and society in general has had to adapt on the fly; the rapid changes regarding restrictions, working arrangements and policy measures have required investors to analyse new datasets in a more timely fashion to understand their impacts; the disruption to industries has been large and the dispersion of winners and losers is wide; and the collapse of cash rates to zero in virtually all developed countries alongside a very aggressive expansion of fiscal policy represents a significant policy shift. And of course, there are likely to be longer run effects too: on the pace and direction of globalisation, on government spending priorities, on the level of government involvement in the economy, on technology and working arrangements, and on future inflation, to name a few. Markets appear to be putting aside many of these uncertainties at the moment.

Our portfolio position

Investing is all about making the best decisions possible given the inherent uncertainty of markets. Our robust investment framework, and the research that underpins it, helps us make better decisions, and we are continually enhancing it to both improve our existing methods, and adapt our methods as the investing environment changes.

As mentioned earlier, we’ve reoriented our portfolios considerably to embrace the new set of opportunities. Beginning in late March, we’ve deallocated capital from government and quasi-government bonds and allocated it to credit across a spectrum of assets. This has meaningfully shifted our active risk away from rates, towards credit. It has also appreciably improved the portfolio’s income generating potential and arguably its diversification (at least with respect to the sovereign-dominated benchmark). However, given the uncertainties described above, we are not at ‘full risk’, and would describe our credit allocation as about 75% through its range.

In rates our core view is that yields are likely to stay anchored at low levels, courtesy of both weak economies and ongoing dovish policy implementation by central bankers. While we think rates volatility, and hence opportunity, is likely to be low, we’re looking to maximise the opportunity by, among other things, researching in detail the new demand and supply environment we are in, as central banks implement quantitative easing trades off against increased supply by governments. We’re also mindful of continually assessing the ongoing viability of the low rates–low volatility view. We still prefer to be a little long duration in both Australia and the US, with a bias for curve steepeners. More recently, we’ve been encouraged by policy developments in Europe, including both the steps towards debt mutualisation with the Eurozone, and the commitment by Germany to (finally) expand fiscal policy meaningfully, and have taken small short duration positions there.

In credit, our view has been that the value presented by the sharp spread widening seen in March more than offsets the COVID-induced deterioration in fundamentals as earnings decline, balance sheets become further stretched and ultimately some defaults materialise. As such, over the last two months we have lifted our hedges on Australian investment grade credit, closed our short in global high yield, and allocated capital to global investment grade, Australian higher yielding corporates, and US securitized credit, while holding our allocations steady in Australian mortgages and emerging market debt. Overall our preference remains for Australian credit, though we are looking to diversify in areas that provide a different exposure to traditional developed market corporate exposure. The recent sharp narrowing of credit spreads makes us more circumspect on the credit opportunity from here, and it may be that we use this opportunity to trim and rebalance.

Overall, the portfolio is well positioned to both capture the opportunities and navigate the risks ahead.

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