Fixed Income

The US now truly at late stage of cycle

With the prospect of inflation growing in the US and the Fed raising rates quicker than is expected, we believe the US is now in the late stage of its cycle. Although recession is still some way off, this is troubling for both bonds and riskier assets.

12/10/2018

Stuart Dear

Stuart Dear

Deputy Head of Fixed Income

Ongoing robust economic activity in the US – in absolute terms, and relative to other countries – continues to define the market environment in 2018. It’s driving US rates and the USD higher, and outperformance of US equities and credit over non-US peers.

On the one hand our expectations have been playing out nicely – strong US growth is forcing the Fed, worried that inflation is already at target and the economy is turbo-charged with tax cuts, to tighten by more than markets have expected. On the other, we also expected concerns around both higher rates/inflation and trade war escalation would unhinge risky US assets, which has not occurred, yet.

Most likely, investors have responded more to the current growth story than to looming inflation risk and slowing growth ahead – making US equities and credit even more vulnerable to extended valuations when these issues do become front-of-mind. To date, the rise in US inflation has only been gradual, and not strong enough to push the Fed to accelerate from its gradual tightening path. Rate rises have not yet been hurting US companies, flushed with strong operating profitability and repatriation windfalls, and have mostly been creating trouble abroad, with USD funding drying up for vulnerable borrowers. Similarly, markets seemingly believe Trump’s ‘win’ narrative on trade wars – against the evidence that protectionism is bad for all – ignoring the impacts on the US but punishing other countries. Goldilocks apparently lives on in the US.

Key to our view on the US is that we expect inflation to continue to lift, and that by consequence the Fed tightens by more than the market expects, into restrictive territory. At this point the US cycle reaches truly late stage, with a deteriorating growth / inflation mix ultimately preceding recession. The path of US rates appears destined higher until the Fed does enough to rein in inflation pressure. Riskier assets may still do okay through this late stage until the recession threat rises more materially, still about 18 months away on our modelling. However, with risk premia low, and volatility likely to lift with rates, we are cautious.  

We’re probably more optimistic than markets about growth prospects beyond the US. Chinese policy is now being eased in response to both the earlier internal slowdown and threats to growth from higher tariffs. Europe decelerated a little earlier in the year but has stabilised, with activity levels still above trend. While broadly impacted by higher US rates and stronger USD, the issues in emerging economies have been mainly idiosyncratic and confined to the weaker countries, including Turkey and Argentina.  However, while growth in non-US developed economies may be okay, an absence of material inflation threat is likely to keep central banks relatively patient – versus both the Fed, and previous tightening cycles.

The Australian economy looks to be making steady progress, with infrastructure spending broadly offsetting housing weakness, commodity prices and volumes up, and unemployment edging down. However, slack remains in the labour market and the weakness in wage growth underlies a soft inflation pulse, affording the RBA time.

Across our portfolios, we’ve been running cautious positioning for some time now, involving shorter duration than the benchmark (currently about 1 one year shorter), exposure to inflation linked bonds, and limited credit risk. Despite persistent underperformance, and hence improved relative valuation, the US Treasury market remains our preferred underweight given the upside cyclical outlook for higher interest rates. In Australia and Europe (especially), bonds are more expensive but the cyclical pressure is weaker, hence we are also short but by a lesser amount. In each case we’re running small yield curve flattening positions to capture eventual policy tightening cycles.  We also have in place explicit inflation protection in both the US and Australia via inflation-linked bonds.

Our credit risk is low both in absolute and relative to benchmark terms. In general, credit spreads are pricing the continuation of an environment of reasonable growth and low inflation – not central bank policy tightening and liquidity withdrawal – but at skinny spreads the best to hope is for earning a little carry. Per our earlier comments, we are avoiding riskier US credit where valuations are most stretched, and prefer owning higher quality, shorter tenor Australian credit. This allows our portfolios to retain a little high quality carry, but hopefully be well protected from spread widening when it occurs.

Altogether our cautious positioning leaves us defensively placed, appropriate against a backdrop of rising rates, higher inflation, and growth risk beyond. Such positioning also allows the flexibility to respond to opportunities as they arise, and we are monitoring developments closely with a view to setting up our portfolios more constructively for future returns.

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