Fixed Income

Tread carefully as the monetary safety net weakens


Stuart Dear

Stuart Dear

Deputy Head of Fixed Income

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After the stellar returns of 2019 – primarily driven by central bank easing – the new decade of investing got off to a bumpy start in January. The Iran missile strikes, coronavirus and, locally, the bushfires, all emerged as new risks to economic growth (in addition to their tragic human cost). While markets have largely dismissed these as noise in the near term, conditioned as they are to ignore ‘risk off’ signals given the assumed central bank backstop to any threat, we think they portend a more difficult outlook ahead. There are several threads to this argument.

Nearing the limits of monetary stimulus

The first is that while global activity data was lifting late in 2019, risky assets have already priced in much of the good news – perhaps too much so. It’s probable that the activity hits caused by recent events will cap growth upside this year at around trend levels at best. If so, risky asset valuations look stretched, both on the current macro outlook and on most medium-term valuation measures.

Secondly, the scope for policy easing in 2020 is more limited than in 2019, both because central banks have already eased and have little further effective (real economy) ammunition left, and because a more decisive shift towards fiscal policy expansion has not yet been triggered by a recession or financial crisis. Australia is a case in point: the RBA has eased but is reluctant to do more in spite of subpar growth and inflation, with the cash rate already close to zero and further easing likely to have both diminishing effectiveness and increased trade-offs. Meanwhile, the slow growth environment is not so bad as to force a meaningful loosening of the Commonwealth purse strings. Despite our view that policy easing will be harder to come by this year, markets have re-kindled the happy bond–stock divergence, with both asset classes buoyed by the presumption of additional policy support.

Taken together, the idea of muted growth and reduced policy flexibility is not a dire macro outlook.  We continue to characterise risks to growth and inflation as being reasonably balanced, following the global growth downshift last year and the subsequent central bank easing. However, after a strong year of asset returns in 2019 that has taken prices to expensive levels, and with markets priced optimistically relative to the macro environment, we are expecting both lower returns and more volatile asset markets in 2020.

A tactical approach to risk management

This has several implications for how we are thinking about our portfolios. Firstly, as always, we remain focused on ensuring our beta allocations are appropriately set to deliver return and manage risk. For return in this environment, we mostly look to earning high quality carry.

Secondly, with the tailwinds of falling yields and tighter spreads mostly behind us, we think it makes sense to adopt a more tactical stance to attempt to capture smaller market shifts, and to look for relative value opportunities between countries and curves.

Thirdly, we remain focused on adding incremental value and controlling risk through security selection. In an environment in which broader asset returns are likely to be subdued, capturing idiosyncratic opportunities will be especially valuable. And finally, we’re thinking even harder about ways to manage capital volatility. For now we’re focused on trying to sensibly hedge the tails of the economic distribution – for example, by owning inflation-linked bonds to hedge against inflation upside, while avoiding global high-yield, which is vulnerable to the downside.

Our portfolio position

We still favour Australian investment grade credit – including both corporate bonds and AAA-rated RMBS – to access high quality income, although in January we pared some of our exposure with spreads at tight levels. Australian mortgages also remain attractive, both on relative valuation to corporates, and as a diversifier to corporate credit exposure. We made allocations to US mortgages and emerging market debt for similar reasons in late 2019 – seeking to diversify both income and risk sources.

In our rates positioning, we’ve now turned the long duration position we held through 2019 into country relative positions: longs in Australia, the US and Canada – where there is greater scope to ease – against shorts in Europe, where monetary policy looks largely exhausted. We’ve also shifted to a yield curve steepening view in the US – driven by the Fed either easing more or staying on hold while the global reflation story plays out.

In addition to the above, a recent focus has been to systematise our approach to integrating ESG considerations in our security selection process. This work continues to strengthen the ways in which we identify value and avoid unrewarded risk.

Overall, the portfolio retains its high-quality focus, and we are working hard to maximise opportunities to incrementally add return and retain diversification. We believe we are well-positioned for a more challenging 2020 return environment and expect actively-managed fixed income to continue to be a valuable portfolio holding in this environment.

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