Low yield yet carry friendly environment
Reasonably rich valuations are preventing significant price appreciation, while at the same time, sensitivity of central banks to financial conditions and market indifference to political developments are limiting the downside.
Several factors including Korean tensions, the threat of a US government shutdown and weather events favoured government bonds over the northern hemisphere holiday month of August, in spite of generally positive economic data. Australian bonds lagged the global move as sentiment shifted towards earlier tightening by the RBA.
Markets remain in a holding pattern. A steadily reflating global cycle, with broad participation across most regions but with no obvious signs of much higher inflation, remains supportive for most assets. However, reasonably rich valuations are preventing significant price appreciation, while at the same time, sensitivity of central banks to financial conditions and market indifference to political developments are limiting the downside. It remains a low yield yet carry friendly environment.
Real rates persist below even cyclically-reduced neutral estimates. In the US, the Fed has lifted the Funds Rate to a 1.00-1.25% band, but even with core inflation undershooting at 1.70% year on year, the real cash rate is still in negative territory. In other locations the degree of accommodation is much greater. In Europe, the -0.40% policy rate leaves the real cash rate – and the real yield on many investments – well below zero. While low yields may be explainable, and even persistent, they challenge both the level and the path to future returns.
Central banks have played a patient game in monitoring the improvement in the macroeconomy. While formal mandates are still driven by inflation and full employment, high debtloads mean the response of financial markets and the interaction of monetary and fiscal policy are significant complications to tightening. This in part helps explain why central banks have been so cautious. Central banks have also been hard at work trying to understand the muted response of the macroeconomy to policy stimulus. The probable moves over coming months, by the Fed to begin reducing the size of its balance sheet, and by the ECB to taper its monthly bond purchases, are welcome developments on the long path towards more normal operation of monetary policy.
While longer term fair value bond yields have been pulled lower by structural factors including the effects of demographics, debtload and technology on potential growth and inflation, a gap – unexplained by the state of the cycle, which has improved considerably over the last year – exists between current low yields and higher fair value levels. In Australia and the US fair value yields according to our models are about 0.80% higher than current, with the gap wider in Europe, the UK and Japan. At low levels of yields and therefore with little buffer to avoid losses, our process continues to suggest defensive positioning remains appropriate until better value is restored. Similarly in credit, with spreads back at post-GFC tights, there’s likely little further capital upside to be gained. While there are few cyclical risks to credit as recession (driving defaults) is not imminent, rather than chase carry at current yields we’d prefer to remain patient for more constructive positioning opportunities at better levels.
As a result, portfolio positioning remains cautious along both interest rate and credit dimensions. In rates, over August we marginally increased our relative-to-benchmark short duration positioning to 0.80 years, reflecting the fall in global bond yields, hence further deterioration in value. With Australian bonds underperforming the move, we also shifted all of our short duration exposure offshore (leaving us neutral to benchmark in domestic rates) – 0.30 years in the US where very little further tightening is now priced, and 0.50 years in Europe where valuations are most expensive. Our preference for higher yielding markets (Australia and the US) over lower yielders (Europe and Japan) remains intact though we have diversified our positioning within Europe by moving some of our short position from Germany to Italy. Finally, we also increased our exposure to reasonably cheap inflation protection via Australian ILBs.
In credit we hold a very modest absolute exposure, about the benchmark weight. Our preference remains for short duration high quality Australian debt over longer and lower quality global exposures, and over subordinated domestic issues. We’re marginally topping up exposures to longer-dated semis and to AAA rated Residential Mortgage Backed Securities (RMBS) which have lagged the spread tightening of other sectors, but in general are contemplating a further reduction of our directional exposure to credit beta. Cash remains elevated and ready to deploy should better opportunities emerge, however we are remaining patient and true to process in the meantime.
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