The increase in instability – originating from the US Fed’s rates increase and volatility in Turkey and Argentina – hasn’t rattled broader risk sentiment, but as we disagree with the market’s position on the Fed’s rates outlook, we’re set up for a different future than most.
In aggregate, the global economy continues to advance at a respectable pace, but policy withdrawal generally, and the increase in US rates and the USD in particular, are generating instability. August saw further weakness in emerging markets, dominated by idiosyncratic news in Turkey and Argentina, ongoing concern about the impact of the US-China trade war, and renewed focus on fiscal sustainability in Italy.
These concerns in several countries have undermined specific markets but not as yet dented broader risk sentiment – witness US equities setting daily record highs and high yield bond spreads holding near lows. Tactically we are expecting these issues to escalate, and risk aversion to broaden. This is likely to involve bond yields staying near the bottom of their recent range – or lower – and riskier assets weakening.
Our more medium-term view centres on the advanced/near-capacity cyclical position of developed economies, likely to drive more inflation and central bank tightening than markets are expecting. This should see bond yields higher, and while risk assets should broadly perform okay in this stage of the cycle, the expensive starting point of many makes them vulnerable to a re-adjustment alongside higher yield and inflation expectations.
Our view on the path of the US cash rate differs from the market, and is more aligned with that of the Fed itself. With growth turbo-charged by tax cuts and inflation lifting, we think the Fed will need to lift the Funds Rate, currently at 2%, up towards 3.5% by 2020. Such a move would put policy in restrictive territory, implying the need to slow the economy as inflation rises. Against the market’s view that 2.75% is where the Fed stops tightening, we maintain a short position in US rates, despite their rise to date.
Growth divergence remains a focus for markets. Relative to the US, Europe has slowed this year, in part due to the Chinese slowdown. We remain optimistic that the European recovery is progressing steadily, and the gradual path of policy withdrawal embarked on by the ECB will continue. However, the relative paces of tightening – with the US leading and the rest lagging – will continue to generate market tension via higher USD costs.
Much of the action in the Australian market this month has been driven by politics but these political changes mean little for the RBA – the economic impact should be limited. During the month the RBA published new forecasts that show that the central bank continues to see growth running at an above trend pace of over 3% in 2018 and 2019. Any lift in wages growth and inflation is expected to be gradual given the evident slack in the labour market. The housing market continues to cool, but appears to be on track for a soft landing. We are expecting the next cash rate move to be up, although not for some time, and recent bank mortgage rate increases are only likely to add to the delay.
We’ve been running cautious positioning for some time now, involving shorter duration than the benchmark, exposure to inflation linked bonds, and limited credit risk. The interest rate short was much larger earlier in the year but we took advantage of yield rises several months ago to buy back duration. We bought further duration in July in anticipation of a near-term risk-off move in markets (now at -0.75yrs relative to benchmark). Similarly in credit, from a small overweight position relative to benchmark, in July we reduced our exposure to a small underweight.
Despite persistent underperformance, and hence improved relative valuation, the US Treasury market remains our preferred underweight given the upside cyclical outlook for higher interest rates. We retain a short duration position in Europe where valuations remain very expensive and bond yields are not reflecting the improving outlook for growth and inflation. Australian longer-dated yields will be driven by global yield moves, so we are comfortable maintaining a small short locally where little is priced for an eventual RBA tightening cycle. The portfolio also has in place explicit inflation protection in both the US and Australia via inflation linked bonds.
Credit spreads are pricing the continuation of an environment of reasonable growth and low inflation, not central bank policy tightening and liquidity withdrawal. Recession risk is some time off but our preference is not to chase the small margins for earning carry but to position for a rebuild of credit risk premium. Usually such moves come faster and with more severity that most investors will anticipate. As such our credit exposure is modest in absolute terms and slightly lower risk than the benchmark. We continue to prefer Australian credit to global, for its high quality and short tenor, though global investment grade credit is starting to look attractive in a relative sense given its underperformance so far this year. Our small global and higher yielding (riskier) exposures are effectively hedged.
Altogether our cautious positioning leaves the portfolio well placed to weather both a near-term bout of risk aversion as well as more medium-term policy withdrawal and associated volatility. Such positioning also allows the flexibility to respond to opportunities as they arise, and we are monitoring developments closely with a view to setting up the portfolio more constructively for future returns.
Published by Stuart Dear, Deputy Head of Fixed Income, Schroders