Commentary: Improved valuations create a better risk reward balance
The reset in yields over 2022 has been a painful process for investors. However, with tentative signs of a peak in inflation and improved valuations for corporate debt, outlook is more constructive for fixed income assets and generating positive returns.
Have we seen the peak in growth and inflation?
The current macro backdrop of high inflation, rising official interest rates, geopolitical risks and rising recession risks presents ongoing challenges and an uncertain environment for asset values. That said, the factors driving price adjustments across markets are now increasingly priced into valuations, which have improved in equities, credit and bonds. This is presenting a more constructive outlook for forward returns and a more balanced risk outlook than we have seen for some time. Central banks remain in play albeit some are adjusting the pace of tightening. The US Federal Reserve and the Bank of England both recently increased rates by a further 75bp, while the RBA has slowed to a 25bp a month pace. Cash rates are expected to continue to rise, but much of this is arguably already priced into yield curves. The transition to higher yields across fixed income markets has been painful but higher yields and wider credit spreads have improved the risk reward balance.
As we look forward, we believe the next phase of the cycle will be growth and inflation falling. Our global economics team model leading indicators for growth and inflation, which suggest growth momentum is declining and will continue to decline to around 2% – and likely further as the recent rate increases start to impact the leading indicators. Inflation is still heading higher, but our leading indicator has peaked and suggests that inflation will fall over the next six months. Both indicators are suggestive of a peak in interest rates as both growth and inflation decline. This should be broadly supportive of credit spreads and investment grade credit should perform well as a good source of income at current yields around 5%. Duration based assets should also benefit with a potential peak in rates priced in.
History warns inflation is stubborn
That said, we are conscious that while inflation appears to have peaked it can be sticky. When we look back in history to periods where inflation moved above 8% it has usually been slow to drift lower. Where it does move lower, it usually settles above where it was before the inflation spike occurred. As such, we continue to assess both the level at which inflation is likely to settle but also the appetite for central banks to live with higher levels of inflation than experienced during the past decade.
Given this backdrop, we have been slowly adding back credit and duration to the portfolio. We removed our 2% short global high yield position and are now holding zero exposure to this asset class. The removal of the short derivative position was driven by the improved valuations and to remove the cost of hedging, in the form of negative carry, from the portfolio. We also added 1% to Australian investment grade credit which has lagged other markets due to a widening in swap spreads in the Australian market.
On duration we again added to the portfolio in Australia and the US as valuations have moved into the neutral range. At close to one year of duration we are in the middle of our -2 to +4 year range. We would expect to continue to add duration as we see more evidence of a peak in yields or as valuations continue to improve.
Bonds still looking better than term deposits
Cash remains elevated although it has reduced, largely through adding credit. Cash levels are expected to decrease as we continue to add to portfolio exposures. One interesting point that clients are raising is the improved yields on bank term deposits. With yields on term deposits having risen off low levels they are attracting some interest. However, we believe that while yields have improved, there are better opportunities for investors elsewhere. Our analysis suggests that term deposits lag the market yields as interest rates rise, because banks are slow to reset term deposit rates. For example, a one year term deposit appears ‘expensive’ as investors can achieve a better yield (up to 90bps) by holding a one year bank bond, which is also liquid and will benefit in capital terms if rates fall.
Currency continues to be a downside risk hedge, although the improved attractiveness of duration means we expect currency exposures to remain toward the lower portion of our historic range. We retain a long USD position which we still believe will be a reasonable hedge in an economic downturn.
Overall, we continue to be defensively positioned with high levels of liquidity through elevated cash levels. The yield to maturity of the portfolio at the time of writing was 4.50%. We are beginning to lean into markets and deploy cash to earn additional carry while also maintaining a focus on managing downside risk, given the ongoing uncertainty of the macro backdrop.