The calm after the chaos?


2020 saw once-in-a century swings in the economy, policy and markets. After that year of chaos, maybe 2021 will be refreshingly normal! Though challenges remain, we think the global recovery remains on a solid footing, strongly supported by policy makers across the globe. In our view, it will be another year of fiscal expansion alongside very accommodative monetary policy, with low yields driving the search for returns.

Since mid-November, bond yields have been rising on the back of the US election and the announcement of several very effective vaccines. As we expected, this move continued in January, helped by the Democratic sweep after the senate elections in early January.

The yield move has been reasonably muted – about 30bps since early November, driven by policy and vaccine optimism. We expect that stronger economic data will confirm this optimism and drive the next leg of yields higher in the coming months.

Reflation, central banks and growth assets

One reason why reflation trades have worked well is because central banks have managed to keep government bond yields (and real yields) from rising sharply. Their yield curve control has been highly effective, keeping shorter-dated securities pinned near the cash rate and allowing for limited yield increases for longer-dated securities.

Central banks would prefer a gradual rise in yields to lower the risk of them falling too far behind fundamentals and resulting in the quantitative easing ‘taper tantrum’ that destabilised markets in 2013. We believe central banks, in particular the US Federal Reserve, understand that risk, and will prevent a replay of the dramatic tightening in financial conditions, as they eventually scale back on their quantitative easing program.  

The more notable performance from the reflation trade has so far come from growth assets, which, buoyed by the expectation of economic recovery amid ongoing policy support, are in most cases now back to spread levels from 12 months ago. This leaves investors navigating a delicate balance. Companies went into survival mode in 2020, reducing costs and ensuring access to liquidity to stabilise their balance sheets, often by taking on more debt. Recovering from a weak position, fundamentals are now improving as profitability recovers. However, valuations on corporate bonds are no longer cheap as yields have compressed significantly and are now arguably expensive.

Nevertheless, we still believe credit allocations will deliver the best returns in the fixed income universe for some time yet. But this outlook is not without risks – particularly in the short term.

Market sectors that have excessive optimism priced in warrant caution. We are carefully participating in the ongoing recovery with selective allocations to asset classes like Asian credit and emerging market debt, which are still attractive. This is alongside broader portfolio positioning for higher yields and more volatility.

Our portfolio position

Our main focus is security selection within our allocations. We are making sure we are positioned in issuers and sectors like transport and property trusts that have lagged the broader recovery, and which will further benefit as the economy reopens. While global investment grade credit has performed extremely well, we have reduced our exposure to this asset class. That’s because valuations are expensive – and this sector is vulnerable to a move higher in yields, with higher interest-rate sensitivity compared to other credit markets.

The reflation trade has also seen inflation-risk premia hitting multi-year highs, with breakeven inflation rates – a proxy for the market’s expected future inflation rate – having moved up sharply and more than reversed their 2020 fall. This increase reflects a dissipation in the perceived downside risks to the inflation outlook, amid a broad-based improvement in global economic prospects.

We believe the risks to the inflation outlook is tilted to the upside. That’s why we’ve rotated some of our strongly-performing credit exposures and invested into inflation-linked bonds which pay a semi-annual coupon that adjusts with the inflation rate, both in the US and in Australia.

Guarding against rate volatility

As well as increasing the portfolio’s exposure to higher inflation, we have been preparing it for higher interest-rate volatility. We continue to see yields on longer-dated securities moving gradually higher under an implicit yield curve control framework administered by the central banks. In response, we have been reducing our duration across global interest rate markets, particularly in US treasuries and in Europe, UK and Canada.

Australia remains our preferred market, with the Reserve Bank of Australia (RBA) remaining extraordinarily accommodative, announcing an extension of their quantitative easing program in February. While the RBA will hold yields lower for longer, with global and local data improving rapidly this won’t prevent the market from pricing in a higher probability of interest rate increases in future.

With yields low, we need to work harder to deliver returns. However, there is plenty of scope for quality income generation across a broad global opportunity set. We are keeping portfolios well diversified, remaining flexible to capture opportunities and manage risk. After delivering our investors a strong performance in 2020, we believe we will continue to deliver returns in a more subdued 2021.

For more on the Schroder Fixed Income Fund, click here. 

Important Information:
Important Information: This material has been issued by Schroder Investment Management Australia Limited (ABN 22 000 443 274, AFSL 226473) (Schroders) for information purposes only. The views and opinions contained in this material are those of the authors as at the date of publication and are subject to change due to market and other conditions. Such views and opinions may not necessarily represent those expressed or reflected in other Schroders communications, strategies or funds. The information contained is general information only and does not take into account your objectives, financial situation or needs. Schroders does not give any warranty as to the accuracy, reliability or completeness of information which is contained in this material. Except insofar as liability under any statute cannot be excluded, Schroders and its directors, employees, consultants or any company in the Schroders Group do not accept any liability (whether arising in contract, in tort or negligence or otherwise) for any error or omission in this material or for any resulting loss or damage (whether direct, indirect, consequential or otherwise) suffered by the recipient of this material or any other person. This material is not intended to provide, and should not be relied on for, accounting, legal or tax advice. Any references to securities, sectors, regions and/or countries are for illustrative purposes only. You should note that past performance is not a reliable indicator of future performance. Schroders may record and monitor telephone calls for security, training and compliance purposes.