While 2019 was a stellar year for most assets, investors would do well to avoid becoming complacent. In a low-growth world with rising asset valuations, fixed interest could come into focus as a generator of reliable, low-risk income, with active management increasingly critical.
2019 was a stellar year for most assets. This naturally sets up a more challenging outlook for 2020. Compared to the start of last year, assets are more expensive, while investors seem similarly positioned and perhaps more complacent – although macroeconomic conditions may also appear more benign, with central banks having eased and with manufacturing and trade data appearing to stabilise.
In an era in which central bank actions are suppressing volatility in both economic cycles and asset markets, in which low rates are encouraging more risk-taking on relative grounds, and in which technological disruption is providing growth opportunities for ‘winning’ companies, investors remain attracted to growth asset classes. However, in our view it will remain a low-growth world, for both cyclical and structural reasons.
Fixed income in focus
We believe that, over time, fixed income is likely to prove as important as ever, not in spite of low yields, but because of them. In a low-growth world, the income certainty that fixed income provides should be highly valued, and at low yields the reduced hedging ability of fixed income should result in broader portfolio de-risking and the acceptance of lower returns.
Fixed income portfolios need to adapt too. As always, income generation and diversification with the portfolio remain paramount. However, given the likely ongoing compression of yield curves and credit spreads in a low-yield environment, managers will be less able to rely on beta for returns, and volatility management will be more difficult.
Recession risks reduced but growth outlook still weak
Turning to the outlook for 2020, we too believe that global recession risks have reduced as a result of central bank easing and recent political developments (including a clearer path for Brexit and the agreement of an initial US-China trade deal). However, we don’t believe that the slowdown which commenced in 2018 will reverse materially.
Growth might rebound to about trend and inflation might lift a little, though the range of outcomes appears narrow and reasonably symmetric. We expect further policy easing in Australia as the economy remains sub-par. While this is likely still a carry-friendly environment, and although valuations of risky assets are not yet severely stretched, we would warn against complacency.
Our portfolio position
Having been long duration through the middle part of 2019, we pared this position in the December quarter. We did this after yields had fallen considerably, central banks had eased to a degree, and there were signs of both sentiment and hard activity data stabilising at lower levels. We’ve now turned the long-duration position into country-relative positions: longs in Australia and Canada – where our views are that further easing will be delivered – against shorts in the UK and Europe, where monetary policy looks largely exhausted, particularly in the latter. Effectively, having captured some of the beta move to lower bond yields via an overweight duration position, and with a lower probability for strong beta returns to continue alongside the low level of yields, we’re now positioned to capture some of the relative opportunities between countries. We also expect the yield curve to steepen in the US – driven by the Fed either easing more or staying on hold while the global reflation story plays out.
We still favour Australian investment grade credit – including both corporate bonds and AAA-rated RMBS – to access high quality income. In the low-yield. world it will be a challenge to sensibly balance income generation with efficient risk management, and we are looking for ways to effectively diversify both income and risk sources. We’ve recently made allocations to US mortgages and to emerging market debt, as this helps diversify traditional interest rate and corporate credit risk, and we are exploring several other opportunities. We are also working hard to maximise the alpha we can generate within allocations.
We continue to monitor both recession and inflation risk to gauge the likelihood of the ‘tails’ to the economic distribution, and while both appear unlikely on a one-year view, more medium-term risks persist. As such, we continue to avoid global high yield credit, which is most vulnerable to growth and earnings disappointment and potential for defaults, given its current tight spread. Instead, we prefer owning longer-term inflation linked bonds in both the US and Australia as inflation expectations are depressed
Overall the portfolio retains its high-quality focus, and remains predominantly tilted towards Australian exposure, though we are additionally seeking to capture several relative opportunities and seek new sources of return and diversification. We believe we are well-positioned for a more challenging 2020 return environment and expect actively-managed fixed income to continue to be a valuable portfolio holding in this environment.
Published by Stuart Dear, Deputy Head of Fixed Income, Schroders