Credit spreads tighten as economies begin to recover

Our Christmas wish for a peaceful month for markets broadly played out in December, though who knows what 2021 will bring? Even though there appears to be a strong consensus that the sailing will be smooth this year, as global economic recovery is underpinned by the vaccine rollout and maintenance of strong policy support, we believe this consensus may be too narrow.

2020 taught us that we need to be extremely flexible in our approach to the outlook, incorporating real time data and policy developments in our assessments. People and economies showed a remarkable ability to adapt to challenging conditions, while policy makers continued to push new boundaries.

Our central outlook for the next 6 to 12 months is similar to consensus: we expect the vaccine rollout and improved mobility to drive economic recovery alongside strong policy support, and for low yields to continue to drive a search for returns. However, we nonetheless need to ensure that our portfolios are prepared for a range of possible market outcomes, particularly as the risks around them shift.

Transition risks for ending policy support

Most of the risks we are contemplating are policy related. Last year showed just how powerful policy has been in supporting economies and markets. While the income support schemes have been successful in allowing businesses to remain solvent and consumers to build a savings buffer, balance sheets remain fragile. Therefore early removal of policy support could be damaging. On the other hand, policy support could eventually be too much of a good thing for markets.  Markets have been conditioned to believe that central bankers will be accommodative ad infinitum. It is ironically an environment of stronger growth – along with higher inflation, and concern about monetary policy tightening ­­– that could be the worst scenario for both riskier and risk-free assets.

The COVID shock accelerated the shift to arguably a new policy era, including near-zero rates and coordinated monetary and fiscal policy easing. Going forward, policy-makers’ willingness and effectiveness in managing the transition risks for economies and markets will be crucial.

Our portfolio position

Although yields are low and there are considerable risks to the outlook, there is plenty of scope to use fixed income effectively to generate income and help manage portfolio risk. We are focusing on positioning for quality income generation across a broad opportunity set, keeping portfolios well diversified and being flexible to both capture opportunities and manage risk. We are also adapting by accessing more low risk alpha opportunities with returns from the broad market probably reasonably limited, and by adopting a more targeted approach to risk management.

We continue to believe that credit allocations are likely to deliver the best returns within fixed income for some time yet. However, although corporate fundamentals are improving as economies recover, the risks for investors have shifted as spreads have now tightened into expensive territory. Consequently, we are trimming our aggregate exposure at the margin in order to protect against downside, while focusing exposure to the assets and sectors we believe have the best potential to participate in the upside of economic recovery. Asian and emerging market debt at the asset class level are attractive prospects, as are transport and property at a sectoral level. Alongside this positioning, we are closely monitoring macro and corporate developments to validate (or otherwise) our recovery thesis.

We are also being more targeted in our approach to duration management. In a low-volatility interest rate environment where central banks have yield curves under administration, this means being more selective about where to hold interest rate risk (which countries and where on the yield curve), and preparing sensibly for higher interest rate volatility. Our view is that yields are likely to gradually shift higher over the next year, but not materially so. The risk, however, is for a more outsized move, against which the cost of hedging is low. As a result, we have been reducing portfolio duration, and particularly have been reducing exposure to US treasuries. This has been implemented through yield curve and cross-market positioning.

Having performed strongly in 2020, the fixed income portfolio remains well positioned to continue to deliver value. We believe firmly that fixed income continues to provide some very important portfolio building blocks – namely quality income generation and risk management tools. However, a shifting policy landscape combined with low yields suggests we will need to stay adaptive to the environment, a lesson well learnt from this past year.

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