Re-opening for business

As we move on from the third quarter the relaxation of COVID restrictions continues. Whilst not even across countries or even regions, the direction towards reopening economies continues. From a purely economic viewpoint it would appear the worst stage of COVID is largely behind us and the world can continue towards normalisation with fewer restrictions on economic activity. However, if fading vaccine efficacy or a more dramatic wave of infections threatens healthcare systems, governments may be forced to reimpose economically damaging restrictions.

Although the COVID picture is improving, global markets over the quarter have been somewhat variable as growth slows, energy prices rise sharply (particularly for those heading into winter) and risks around more persistent inflation heighten. Natural gas prices have soared in Europe and a severe power shortage has shut down a big part of China’s manufacturing activity. On the inflation front, a mix of slowing growth and inflationary supply shocks threaten stagflation.

In terms of portfolio changes over the quarter we made a few adjustments. Last month we indicated we were cautious on US high yield valuations and were watching for any potential catalyst to cause spreads to widen. As September progressed and spreads continue to grind tighter, we moved to reduce our exposure by 2% given tight spread levels. After the reduction we have seen some spread widening towards the end of September. Whilst the moves have not yet prompted a move to add back to our exposure, we continue to monitor closely.  

We increased our exposure to Asian credit during September as its currently stands out as one of the more attractive asset classes from a valuation perspective. Asian credit has come under pressure recently due largely to a regulatory crackdown in China in several sectors. In particular, the Chinese property market is being negatively impacted by ongoing issues with large construction and development company Evergrande. We do not hold Evergrande debt in our portfolio (which highlights the importance of bottom-up stock selection in avoiding problem credits) but there was some contagion to credit spreads across other issuers and sectors.  We do believe that the higher yields provide good compensation for the higher volatility and uncertainty in this sector although we are watching future developments closely

The remainder of the credit exposure was largely unchanged. We continue to prefer investment grade credit and still see benefit in holding exposure across Australia, US and Europe. US securitised debt is also interesting. It provides diversified exposures to the consumer market segment with a yield of close to 2% and low duration exposure, hence little interest rates sensitivity.

We have also retained our allocations to emerging market debt through an absolute return strategy. This provides additional diversification with a downside risk-managed approach that complements the broader portfolio holdings.

In terms of currency positions, we closed our long British pound (GBP) and long Euro (EUR) versus the AUD exposure. This provided positive performance and was originally implemented to provide exposure to the reopening trade in Europe to offset the ongoing lockdowns in Australia. As the roadmap for Australia to begin reopening became clearer we removed this exposure. We have retained our long USD and JPY exposures combined at 3% of the portfolio which acts as a downside risk hedge and should assist the portfolio in the case of a dislocation in risk assets.

Duration positioning was largely unchanged. We hold low levels of duration at the total portfolio level. Of this, we have a long position in Australia. We are short duration in the US on the view that upward pressure on bond yields is more likely in USD-based assets if we see structural inflation risk rise or the US Federal Reserve (Fed) adjusts its narrative around tapering. We have also retained our short position in the US inflation linked securities at the 5 year part of the curve.

Looking at the big picture

Overall, whilst valuations in credit market are in the expensive range, we don’t see a significant selloff in risk assets as imminent. Whilst global growth momentum has peaked, growth remains above trend and COVID-related reopening continues – albeit not in a linear fashion. Monetary policy settings and fiscal stimulus remain a positive force for risk assets as does the current predisposition of central banks to act when volatility spikes. Leverage in credit market has risen, however debt serviceability is high with interest rates low, margins remain sound and default rates are low.

That said there are clearly challenges ahead including the threat that inflation is more persistent than transitory. Although the reaction function of the Fed is expected to be slow (for example initial talks of tapering were clearly separated from rate hikes which are still way into the future) the market pricing can adjust and pressure the Fed’s timeframe. We are seeing some divergence in central banks across the world. For example, New Zealand, although a small part of the global economy, has recently hiked rates moving to a less accommodative monetary policy stance. It may not mark the start of a global tightening cycle, but it is worth bearing in mind.

As we move forward, balancing the fund’s return target and the risk target (no negative returns over rolling 12 month rolling periods) will require continued focus not only on the top-down asset allocation across global credit assets but also the more micro aspects of portfolio management. A low yield world means cross market opportunities, relative value, and yield curve positioning as well as active stock and sector selection will continue to be important areas of focus. We believe that an active, diversified multi-strategy approach is preferred over a single or narrow asset class selection to balance the portfolio and navigate through the future uncertainties.

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