Fixed Income

When opportunities come knocking


Stuart Dear

Stuart Dear

Deputy Head of Fixed Income

The September quarter delivered further turbulence across markets, driven by renewed falls in commodity prices, persistent concern around a Chinese hard landing – helped by the RMB devaluation – and (putting these two together) growing anxiety about emerging market economies. Uncertainty about Fed tightening and its impact on both economic outcomes and market liquidity conditions frayed market nerves, and continues to do so beyond the FOMC’s September meeting ‘pass’. Credit spreads moved meaningfully wider, especially on lower-rated global bonds, while sovereign yields fell. Australian bonds outperformed most global peers.

Our approach is defensive by design, as our focus on absolute returns and our strong valuation anchor ensures we steer away from expensive assets. September was an ugly quarter for markets and a good time to be defensive. A significant widening in credit spreads led to poor returns from credit assets with global high yield debt returning -4.9% in the quarter for a year to date return of -2.5%, while global investment grade also struggled, delivering just +0.4%q/-0.3%ytd (all in USD hedged terms). Sovereign bonds delivered above-cash returns, with Australian governments returning +2.4%q/+2.8%ytd, and US governments +1.7%q/+1.8%ytd (in local terms), though these returns are considerably below those associated with periods of weakness in risk assets over the last several years. The outcomes for the Strategy (+1.48% pre-fees) over the quarter reveal our defensiveness in an absolute sense, but not in a relative sense as the sovereign-dominated domestic benchmark (+2.20%) beat virtually all other assets, including cash.

Our defensiveness has been reflected in a high cash weighting, a consequent underweighting of bonds (interest rate risk) versus benchmark, and only moderate credit exposures. Why? Over the last 12-18 months we have highlighted the gap between investors’ perceptions of risk in asset prices and the implications of extended valuations on future returns. Consistent with this has been the link between asset prices and the aggressive reflationary monetary policies pursued by major central banks – especially the Fed, but more recently the ECB and the BOJ. Our essential argument with respect to asset prices is that whether you look at bonds or equities, risk has been mispriced. Despite the recent declines in equities and widening in credit spreads this remains the case.

Credit has been a star performer in the post GFC environment, benefitting from the combination of low bond yields, narrowing credit spreads (amid the search for yield) and a broadly improving economic environment meaning limited defaults. Cracks started to appear in credit just over a year ago when declining oil prices started to unravel the debt of US energy producers. This reflected pressure on cash flows, concerns over refinancing, as well as worries about the overall viability of parts of the industry given their costs of production. Since that time, credit spreads have broadly continued to widen, aided by increased supply at longer tenors (as borrowers look to lock in low rates for longer), signs of deterioration of corporate financial health, and growing concerns around credit market liquidity in the Basel 3 regulatory environment.

From a valuation perspective we believe the now significant widening in credit spreads means valuations have shifted from expensive to closer to fair value. The real risk for credit is recession as this is the environment where corporate defaults rise and spreads widen commensurately. Despite growing market rhetoric, we believe this is a relatively low risk at present.

Emerging market debt remains a troubled asset class as both the weakness in Chinese demand ripples through to other emerging economies, and as the stronger USD and potential Fed tightening continues to support a flight of capital away from these economies. Although EMD has cheapened materially, the asset class is not yet attractive enough to properly compensate for the inherent volatility and downside risk embedded in it.

Sovereign bonds remain perhaps the most difficult asset class from an outlook perspective. Valuations are at the core of our approach and while we generally accept that in the short run valuations are a poor forecasting tool, they matter over the medium term. Valuations are expensive versus even conservative estimates of normality, yet given the laboured path of global recovery and the growing addiction (of both policymakers and markets) to unconventional monetary policy, it is conceivable bonds stay expensive even beyond the medium term. That said, the low levels of current yields (negative in some cases) imply a high likelihood of very low future returns from sovereign bonds, and additionally there is growing evidence that at these low yield levels, bonds begin to lose some of their power as a key defensive asset, as yields have limited room to fall.

With recent falls in commodity prices partly indicative of weakness in global demand (as well as changes in supply), markets have priced weaker cyclical inflation. The environment that would see the best return from bonds would be one of broad based and protracted deflation – a scenario we do not see as likely at this point. The more likely scenario is that yields start to move higher and back towards something more sustainable in an undistorted world. An unwind of distortions may not just involve the major central banks moving away from unconventional policy, it may include an unravelling of the large holding of reserves built up by developing economies and currently redeployed largely in the major bond markets.

The Fed, for its part, seems to understand its central role in financial market stability and the growing dangerous reliance of markets on policy accommodation. To this end, we continue to believe that the Fed will begin raising rates soon, to help limit the distortions, to lean against the elongated US recovery, and to provide some policy flexibility for the next downturn. We expect further volatility around the Fed’s policy changes and their interactions with an unbalanced world (via a stronger USD), but ultimately see a more balanced pricing of risk as healthier for markets than their current state.

Portfolio changes during the quarter mostly involved becoming even more defensive in July and early August, as we pared our credit exposure back to almost benchmark weight. The de-allocation was mainly from our global investment grade exposures. This reduction continued our long retreat from credit – edging away from rich valuations, and more recently on concerns about liquidity and some deterioration in credit fundamentals – over the last several years. We did make a small allocation back to Australian corporates during August’s volatility but to date we have broadly remained circumspect about the developing opportunities. The recent widening in credit spreads does make the asset class a more stable and attractive portfolio holding that is likely to deliver relatively stable core returns in the absence of a recession, hence it is likely we will re-engage credit. In line with our caution on credit we continue to run a collective underweight position to the non-credit spread sectors (i.e. semis and supras) given the modest additional return they offer versus government.

Preserving capital as markets adjust is a priority. In addition to our credit positioning, this has meant that we have held a high cash weight and less duration than the valuation-agnostic benchmark, though this has cost us in relative terms. We continue to run interest rate duration at 1.6 years shorter than benchmark, primarily because core sovereign bond yields remain considerably below fair value levels. Most of our short is in the US, reflecting our view that the US leads the cyclical recovery among developed economies, while we also have smaller short positions in Germany and Australia (the latter of which also constitutes a material long absolute Australian duration position given our relatively downbeat views about the domestic economy). During the course of August we slightly moderated the size of our US short, and rebalanced our yield curve exposure to be more short at longer maturities than previously, though broadly speaking our yield curve exposures are evenly distributed to protect both against Fed hikes causing repricing at the short end, as well as a possible rebuild of global term premium at the long end. Effective cash remains around 30% and the Portfolio is well positioned to continue to provide defensive absolute outcomes and be able to take advantage of the developing opportunities.

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