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Thoughts from the Melbourne fixed income desk

Investors like narratives. They serve a dual purpose of explaining past performance, and justifying current portfolio positioning. Narratives also complement consensus estimates of growth, inflation and interest rates, by offering insights into cross currents and underlying drivers.

The narrative on global interest rates has reversed course over the past 12 months.

In the United States, the market is pricing 3-4 rate cuts over the next 12 months. A rate cut in July is more than fully priced by the market – meaning it’s now a question of whether the Federal Reserve cuts by 25 or 50 basis points at its next meeting. The narrative in 2018 focused on a tight labour market leading to wage and broader price inflation. The current narrative is focused on uncertainty over trade policy and earlier rate hikes causing corporate profits and investment to slow.

In Australia, the market is pricing 1-2 rate cuts in addition to the two already delivered by the RBA. The narrative in 2018 focused on a falling unemployment rate leading to better wages growth. The current narrative is focused on tightening credit standards, falling house prices and a multi-year household deleveraging (okay….the last one is just us).

In China, the market is pricing an extended period of loose financial market liquidity (the China equivalent of rate cuts) and proactive fiscal policy to support growth. The narrative in 2018 focused on strong trade growth and regulatory measures to promote financial stability. The current narrative is focused on measures to support the economy and the labour market, largely at the expense of financial stability.

The drawback of narratives is they lag market pricing. Subscribing to the above views and adding overweight duration positions is unlikely to deliver good investment outcomes.

We focus on identifying differences between our own narrative and the markets’, increasing position sizes when the market moves towards us, and exiting when they become the same. This is why we’ve largely exited our overweight duration positions in the United States and Australia.

One economy stands out as having a conflicting narrative. Despite the wave of bearishness sweeping across global interest rate markets, Canadian interest rates continue to price the goldilocks outcome, at least in a relative sense.

Our forward-looking indicators of Canadian growth signal a sharp loss of momentum over the next 6-12 months. Trading partner growth momentum is weakening, financial conditions have tightened (a headwind for growth), and corporate profits growth is the worst since oil prices collapsed in 2015. Retail sales growth may also slow due to Kawhi Leonard departing the Toronto Raptors for the LA Clippers!

Trading partner growth….momentum is weakening

Financial conditions….have tightened

Corporate profit growth….worst since oil prices collapsed in 2015

The current narrative in Canada is focused on booming employment growth which should lead to better wages growth. We expect the narrative in H2 2019 will be focused on slowing growth and a rising unemployment rate, which will ultimately lead to the Bank of Canada cutting interest rates several times over the next few years. Currently the market is pricing only 10 basis points of rate cuts over the next 12 months.

We are currently overweight duration in Canada, and it is now one of our key macro positions. We will look to increase the position when the above factors become a more prominent part of the market’s narrative.

 

Published by Andrew Canobi, Director of Fixed Income at Franklin Templeton and co-portfolio manager of the Franklin Australian Absolute Return Bond Fund.