Minor adjustments ahead of global headwinds
In our last commentary we discussed the disconnect between global rates (pricing cuts) and risk assets (continuing to rebound), and suggested that the year-to-date dovish central bank shift – and possible ‘fine tuning’ easing – could explain this. A little FOMO could also be playing out because although investors are worried and uncertain about where we are in the global cycle, they aren’t prepared to miss the higher possible returns on risky assets in a low yield world.
For most of this year, we’ve been neutral to modestly constructive on rates, and a little long credit expecting the carry environment – supported by central banks and still generally benign macro – to continue to play out. However, around the end of March we made a shift back to shorter duration positioning looking for the global data pulse to improve, with the initial adjustment to higher tariffs appearing to be mostly in the data, some policy easing having already been implemented (notably in China), and financial conditions having improved alongside markets.
To date the data rebound has been patchy. Lumpiness of monthly data appears to have overstated the strength of Chinese data prints in March, while a broader turn in manufacturing and trade data remains elusive. Sentiment continues to weaken, somewhat at odds with the hard data, including employment which continues to hold up well in most countries. Meanwhile inflation remains soft relative to central bank targets, and combined with the slowdown in growth over the past six months, has both supported the dovish shift and renewed confidence by markets.
Although it’s not yet clear that the near-term trough in global growth is in, we continue to expect a reflation theme to play out over the next six months or so. Reasonably critical to this will be restored confidence in global trade links by manufacturers, and successful ongoing Chinese domestic policy support.
Beyond this ‘reflation window’, we expect to position more decisively for a US/global downturn. The US is the economy where we probably have best clarity on the cycle: the upswing has been most pronounced in the US, and the Fed has tightened. The US therefore likely gives us the best opportunity on the way down. However, even with the US there is considerable uncertainty about the cycle – our recession modelling is still suggesting recession is 18-24 months away, but can the Fed pause prolong this? Given the cyclical uncertainty, we’ll be watching data and market developments closely.
The RBA faces a different problem to the Fed because it never managed a hike, and now is being pressured to ease. Australian policy ammunition is still more plentiful than elsewhere, but we face the same global issue of reduced sensitivity of the real economy to policy support. The RBA has shifted slightly more dovishly in indicating it will cut if unemployment does not fall as it forecasts.
Meanwhile, valuations of most assets are expensive. However, with the cycle mixed and central bank support being reapplied, this may stay the case for some time. In certain areas too, the micro is holding up better than the macro; for example, US earnings have remained okay and are being rewarded by the market. Nonetheless, we are mindful of limited upside in many assets and run underweight positions in the most expensive segments. We are looking for opportunities to access better value segments of the global universe, including in US mortgages and Asian credit.
In rates our directional risk is smaller than in recent years, as the current case for large moves appears limited. This year we’ve been managing our aggregate duration exposure within a small range either side of benchmark, running small long Australian duration against neutral or small short US and European duration. Around the end of March we shifted shorter in both Australia and the US, but more recently have bought some of this back. Other key rates positions are our US yield curve steepener, and exposure to inflation-linked bonds in both Australia and the US, though we have trimmed the latter recently. While now being positioned modestly short duration relative to benchmark, we expect to be adding considerably more duration to the portfolio on opportunity through 2019, as the US economic cycle ages further.
Despite valuations being expensive, our assessment of the time to US recession and underlying credit fundamentals means we are happy to hold higher quality credit for carry, but are cautious in building a significant exposure to credit at this point in the cycle. At some point, risky assets will face the headwind of either much weaker growth or rising rates/liquidity withdrawal. Hence to manage this tradeoff between earning income for the portfolio and managing the risk of valuation adjustment, we’re positioned long Australian investment grade credit – the best return-for-risk asset in the fixed income universe at present – but short in US high yield. We’ve recently been adding a little to Australian credit – via investment grade, mortgages, and even higher yielding corporates – and per our above comments are looking for other ways to diversify our high quality exposures.
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