In a dramatic quarter, assets repriced sharply lower, led by concerns that surging inflation will force hyper-aggressive tightening by central banks. Bonds led the selloff, with yields peaking in mid-June before recession fears began to dominate, however credit assets continued to weaken. The Bloomberg Ausbond Composite Index returned -9.46% to complete the worst six-month period on record.
We are becoming more confident the repricing of interest rates is nearing an end and have begun rebuilding long duration exposure. Our credit positioning remains defensive, but we expect to be shifting more constructively. Fixed income is offering much better absolute value following the repricing, and good value relative to other assets given the challenging cyclical outlook.
Key cyclical views
The cyclical picture is challenging, as central banks are aggressively fighting inflation at the same time as growth is decelerating. Our key views regarding the cycle are:
- Inflation pressures appear to be peaking, imminently in the US, and by year end in Australia. However, inflation may not recede greatly, as labour markets remain tight, pushing up wages and services inflation more broadly, and food and energy supply disruptions remain persistent
- Growth is clearly slowing, but activity is holding up better than sentiment. Consumers are vulnerable to a real income squeeze on consumption, higher rates in indebted countries (such as Australia), and eventual weakening in labour market conditions
- Corporate profitability will come under pressure both as volumes soften and as cost pressures crimp margins. Markets appear too sanguine about this risk
- The central bank tightening cycle is currently in its most aggressive stage. Bond yields and credit spreads have arguably priced most of the official interest rate and liquidity withdrawal impacts, but are priced for neither ongoing high inflation nor a growth recession
- Policy error risk is high; because central banks are acting belatedly, they are now moving very quickly with little time to assess the effects of tightening. Given the hawkish shift, tightening to at least neutral seems guaranteed, but this is unlikely to be the right level, and with high levels of uncertainty, policy paralysis beyond this point could develop.
It seems probable the post-GFC economic and market environment has ended, however not as intended. The RBA and other central banks were caught flat-footed by an inflation surge, and have been forced to abandon stimulatory policy well before strong growth could help reduce the debt burden. It remains unclear what the next regime will be, however in our assessment:
- Economies and markets are undergoing a dramatic adjustment. Economies are adjusting to accelerated labour market and energy supply disruption, and markets to significantly tighter central bank policy
- Macroeconomic volatility is likely to stay high, with an elevated risk of stagflation. Greater risk premium in most assets is required. High rates volatility and wider spreads in less liquid markets (such as Australia) suggests much of this is priced into rates
- Bond-equity correlations are subject to a positive shift should inflation stay elevated, causing a rethink on traditional portfolio construction techniques. Some alternative asset ‘safe harbours’ may prove illusory.
As described above, the cyclical picture is becoming more supportive of bonds and valuations are much more appealing than at the start of the year or even three months ago. The strategic value of fixed income has also improved with higher yields and a potentially more uncertain, higher volatility environment.
- We are moving to a more positive view on rates exposure, as cyclical risks are shifting from upside inflation to downside growth
- We expect central banks to stay hawkish and deliver aggressive hikes in the next few months as inflation remains high. We are therefore continuing to position for yield curve flattening, staying short duration in short-dated bonds, but moving long duration in maturities beyond 2023
- As official rate increases are delivered by central banks, we expect to increase aggregate portfolio duration
- Credit faces a very uncomfortable macro mix, with downside growth and profitability risk adding to liquidity headwinds. However, spreads have moved significantly wider already, and while we believe riskier credit is still vulnerable, higher quality corporates offer good carry especially on an all-in-yield basis
- We remain defensively positioned in credit but our most recent steps have been to tentatively add back. We will become more constructive as recession risks are increasingly priced.
In no sense are we relaxing, as the next six months or more could prove as challenging as the last, however we are now optimistic that better fixed income returns are ahead and that fixed income will retain strong strategic value to diversified portfolios. Our portfolios are well placed to deliver on both.