Commentary: Braced for continued volatility

Outlook Remains Challenging

Following on from a reasonable month in July, markets once again struggled as they moved through August. The possibility of a ‘Fed pivot’ being priced during July came to an abrupt halt following comments by Jerome Powell at the Jackson Hole symposium. Powell indicated the importance of price stability and reducing inflation, despite the fact this is likely to require a sustained period of below-trend growth. This more hawkish rhetoric pushed bond yields higher.

To say the transition to more appropriate monetary policy setting has been painful to date would be somewhat of an understatement. Duration based assets have borne the brunt of the moves and in performance terms many bond indices have recorded double digit negative returns. For example, global bond markets as represented by the Bloomberg Global Aggregate Total Return have officially entered a bear market for the first time since they started back in 1990. The 20% fall has effectively wiped out over a decade of gains.  

The playbook has changed

Clearly there is significant further policy tightening currently priced into bond markets. Valuations have improved and risk has become more symmetrical. However, we would caution on aggressively adding duration exposure at this stage given bond yields could still move higher from here. Anchoring to the last decade in rates suggests that the move has been sizeable, and we are closer to the end of hikes than the beginning. Taking a longer-term view, current interest rate settings are not especially high compared to history and are not yet in restrictive territory. With inflation continuing to be a significant issue, the central bankers play book has arguably changed. Given the choice between fighting inflation or going into recession, fighting inflation is the lesser of two evils. Killing off inflation, potentially at the expense of growth is in stark contrast to recent history where the absence of inflation allowed central banks to ease policy in response to asset price weakness. 

Currently the expectation is that headline inflation, at least in the US, has peaked and will begin to roll over. The next challenge will be where it settles, given there is a reasonable chance core inflation will remain at levels above the Fed’s inflation target and hence the battle to tame inflation will need to continue. That’s not to say that the market won’t ebb and flow between pricing a Fed pivot and continued rate hikes. With the market analysing every word from the Fed and looking for hints in the path of rates, we expect volatility to remain high going forward. This stands to reason, given greater uncertainty around the path of potential outcomes and a data dependant central bank. Higher volatility can bring opportunities, often in the form of higher risk premia. It can also bring challenges in portfolio positioning. Larger and quicker short-term moves make it even more important to differentiate the noise from the signal and avoid being whipsawed by markets.

Yields could move higher

In contrast to sovereign bond markets, credit markets seem somewhat complacent, particularly in the high yield segment. Investment grade credit is currently pricing in a recession which is consistent with our base case. With outright yields around 5%, given the move in base rates and credit risk premia, this looks more attractive and is higher in yield than what sub-investment grade bonds were providing 12 months ago. Yields could move higher, but the breakeven level is more attractive.

Global high yield, however, is pricing in a more benign economic environment and is not pricing in recession at this stage. Hence, we see the tail risk of much wider spreads in high yield as remaining high. As liquidity is withdrawn from markets via quantitative tightening and funding costs increase at a time where earnings risk is rising, defaults are expected to increase from the current low level. This heighted risk of loss due to default requires a higher credit spread to compensate for the risk. Whist we see valuations in the neutral range from a historical perspective, a move to positive valuations would require a spread 700bp higher. This leads us to play this market from the neutral to short side.

Market outlook

Overall, we continue to be defensively positioned with high levels of liquidity through elevated cash levels. We believe we are still in the transition phase and could bring about a significant shift beyond anything we have seen in recent history. Hence, we remain focused on high-quality carry and managing downside risk, whilst maintaining adequate liquidity. We have been able to increase the yield of the portfolio as base rates have increased and hence the yield to maturity has moved closer to 3.5% despite holding 38% in cash.   

Currency continues to be a downside risk hedge, given duration has been ineffectual, however we are holding reduced exposures. We retain a small long USD position which we believe will be a reasonable risk hedge in an economic downturn.

While this may seem a pessimistic backdrop we are conscious that markets don’t tend to move in a straight line and we can’t rule out an environment for risk assets to perform well. Valuations have improved and the resolution of key issues around growth, inflation, recession risk and geopolitics can see meaningful moves in markets. As such, our active approach leads us to continually assess market conditions and be ready to shift the portfolio accordingly.

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