Steering a steady course

Following the very dramatic moves late in October, fixed income markets were more settled in November – but we did see weakness come through credit markets over the month. Credit had been relatively well behaved of late, reflecting solid earnings and high levels of debt serviceability. However, with many segments fully priced there is a greater sensitivity to weakness in risk assets. This came to the fore over the month as uncertainty about the Omicron variant added to existing concerns to both inflation and growth. Developments in the Chinese property market also continued to unfold as Evergrande nears default. At this stage it looks as if the systemic risk is contained, but restructuring will take some time.

Recent rises in bond yields driven by expectations of future adjustments to official interest rate settings took a break over the month. The October spike in bond yields looked like an over-reaction  as yields moved generally lower in November. Despite low levels of duration, the yield moves did contribute to portfolio returns at the margin.

Currency exposure were a small contributor over the month as the Australian dollar (AUD) was broadly weaker versus the US dollar (USD) and the Japanese yen (JPY).

Previously, we discussed the view that the medical elements of the Covid-19 pandemic had likely peaked. That wasn’t to suggest the pandemic was over and that Covid was defeated, but that as vaccination rates were increasing we were in a ‘living with the virus’ phase. The risk to this view was always the emergence of a strain that is more transmissible or evades vaccines. The Omicron strain has emerged as that risk. It is purported to be more transmissible than Delta, and vaccine efficacy (as well as the extent of severe health outcomes) remain uncertain. This will remain unclear over the shorter term although early signs are promising.

Goodbye ‘transitory’ inflation

Risk assets fell as news of the new strain emerged. Arguably markets had become somewhat complacent – particularly given the backdrop of uncertainly around the growth and inflation outlook as well as the uncertainty about the pace of response from central banks. Inflation in the US continues to be a key focus with the latest CPI release showing headline inflation of 6.2% year-on-year, which was higher than expected and highlights the ongoing inflation pressure in the economy. Current monetary policy settings appear overly accommodative for the economic outlook and it’s clear that central banks will need to act. The question is when, how quickly and how much.  

The US Federal Reserve (the Fed) is under increasing pressure from Congress and the market to address inflation. Fed chairman Jerome Powell told Congress it was time to retire the word “transitory” when discussing inflation and said he was open to a faster tapering of bond purchases. This was viewed as signaling an increased chance of earlier rate hikes. This liquidity withdrawal from the Fed and the expectations of higher official rates is occurring at a time where a potential economic slowdown is before us. It is this mix of rising inflation, possible slowing growth and central banks raising official rates and removing liquidity which is front of mind when positioning portfolios.

Portfolio positioning

In terms of portfolio changes we have been actively reducing overall risk over the last few months and rotating our exposures across different credit sectors. We reduced our allocation to emerging market sovereign debt due to the negative impact that upcoming US rate increases and a potentially stronger USD will have on many developing countries.

We added to the US securitised credit allocation, which is lower risk, on the view that exposures to the US consumer would remain well supported given the upward pressure on income levels and that the elevated savings rate would be broadly supportive for the US consumer debt. We also added to Asian corporate debt. This segment is the most attractive on a valuation basis and we believe investors are being suitably rewarded for the higher volatility and risks. At this stage challenges within the Chinese property sector appear to be under control as Evergrande begins a restructuring process and the systemic risks from this asset class have fallen. That said, we are watching this space closely to identify any risks of a disorderly workout process.

Towards month end we took advantage of a short-term spike in high yield spreads, caused by Omicron, to add back some additional exposure to our global high yield position. We had significantly reduced exposure over the third quarter as yield spreads moved to historically tight levels. We remain comfortable with the fundamentals of the high yield market – earnings have been solid, leverage manageable and credit quality is improving – so the move higher in yields was a good opportunity to re-enter the market at much better yield levels.

In terms of duration, we have made no material moves over the month. We continue to hold low levels of interest rate risk as we are concerned bond yields are likely to move higher over time. The current adjustment phase resulting in the removal of quantitative easing and eventual official rate increases will likely to cause bouts of volatility. These adjustments rarely happen in a straight line, and as such we are cautious. When it comes to positioning we are marginally long duration in Australia and short duration in the US, where the Fed is likely to act quicker than the RBA. As we move towards monetary policy settings, which are more consistent with the current growth and inflation expectations, we will look to extend duration and capture higher yields from longer dated maturities.

In terms of currency, we did make some adjustment to long USD and JPY positioning. We reduced the long USD exposure to take profit from recent strength as it moves to the bottom of the recent range. At the same time we added to the yen position. The JPY has appreciated less against the AUD and hence rotating into this currency provides better valuation support whilst also continuing to provide a downside risk hedge. This is particularly relevant given the low levels of duration in the portfolio.

Looking forward we are focused on managing capital volatility. As markets move through this adjustment phase, we believe there will be a repricing of assets. Our role is to balance the overall risk and return of the portfolio through active management of credit exposure, interest rates and currency exposures. When risk premia are compressed, as they are currently, we typically hold higher levels of cash to minimise portfolio volatility and take advantage of cheaper valuations as they arise. We are cognisant that this results in weaker shorter-term performance as cash is the lowest yielding asset. As we move through this adjustment phase we will be looking to deploy cash as opportunities arise and we establish a more constructive portfolio positioning at higher yields to rebuild returns and deliver income.

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