Central bank groupthink across the world means that although inflation targeting has largely worked over the past three decades, effectiveness has waned and become marginal.
There are patches where data is either stable (such as the US labour market) or moderately improving (Australian housing), but in aggregate, downside growth risks remain. The key risk is that global business sentiment sours further, and labour is retrenched.
Central banks are responding to the risks, but with diminishing marginal effectiveness. Markets now have greater faith in central bankers supporting asset prices than in them achieving their real economy objectives, including hitting their inflation targets. However, by extension, markets should be more worried about a failure of corporates to sustain earnings in the face of weakening growth. While equities are most exposed to this risk, credit is too, with default probabilities higher as earnings falter.
It’s hard to know when a tipping point is reached – if indeed there is one. With the Fed having tentatively embarked on easing in July, the recent escalation of the trade war may trigger a market riot and force the Fed to ease more aggressively. In turn, Fed urgency may extend the cycle – or avoid a recession – largely through financial conditions easing; however, in net terms the easing is unlikely to improve the economics much, considering the economy’s weakened starting point and muted policy effectiveness. Eventually it seems likely that central banks will need to change regimes, but with established inflation targeting frameworks – which in fairness have actually been pretty successful on average over the past 30 years – and a degree of groupthink across countries, they are unlikely to change tack any time soon.
Australia’s situation is different to that of our major economy counterparts in many ways, with our variable rate structure and housing’s larger share of the economy (which together have made monetary policy more effective), greater fiscal space, a shock-absorbing currency, and connections with Asia. However, we haven’t avoided the low inflation disease, compounded by our need to relatively deflate prices and wages over recent years to become more competitive. Hence, although we’re not especially worried about recession in Australia anytime soon, we think the RBA will ease further, with governor Lowe’s cries for fiscal expansion and structural reform going largely unanswered in the near term.
The low yield world is creating many challenges for policymakers, but also investors. With bond yields this low, investors can be lured into reaching for return in riskier assets. Central bank liquidity provides a degree of support, as do relative valuation arguments. However, with bond cashflows much more certain, and the earnings risk flagged above particularly elevated if central banks can’t stabilise growth, we think fixed income remains appealing. We also think diversified, defensive fixed income solutions are a reasonable home for part of a portfolio’s cash allocation, as a way of sensibly enhancing yield a little without compromising too much on the liquidity and certainty that cash provides.
Over the June quarter we significantly increased the portfolio’s duration, although we trimmed it a little in July. In particular we bought US duration, which given the stage of the US cycle and the current policy settings offers the best protection to downside economic risks. Alongside the duration buying we trimmed our US inflation-linked exposure. In Australia we’ve continued to run a small long-duration position as the RBA resigns itself to a lower-for-longer approach, and similarly have trimmed our inflation exposure. In Europe we’ve been running a small yield curve flattening position with the ECB needing to stimulate more – whether by bond buying or other measures – but being constrained in lowering the already negative cash rate much further.
Our credit position is best summarised as being long in high quality Australian debt and short in lower quality global debt, which leaves us earning a small amount of extra carry versus the benchmark, but positioned to capture some of the likely widening in credit spreads as market volatility increases. Our preferred allocations are to Australian investment grade and mortgages. We’ve also been seeking ways to maintain yield, diversify exposures and efficiently manage risk. This is a challenge as there are few pockets of value left; however, volatility does create opportunity.
Altogether the portfolio stands ready to navigate what appears to be a difficult environment ahead with economies fragile, but little room for policy error.
Published by Stuart Dear, Deputy Head of Fixed Income, Schroders