Prospects remain difficult
The reprieve given to financial assets in May was relatively short-lived as the rout in equity and credit markets resumed in June. As market attention shifts from inflation risks to growth prospects and rising recession risks, equities and credit have struggled while bond prices have benefited from generally higher government bond yields. low at the end of the month.
Bond market volatility, as measured by the MOVE Index, has peaked and remains high and near levels during the pandemic. This highlights the challenges with duration-based assets and the uncertainty surrounding the reaction function of central banks as they try to walk a tightrope between managing inflation and the outlook for a slowing economy. growth. The possibility of central banks staging a soft landing is, in our view, remote as they need to tighten monetary policy in a slowing economy. Central banks were caught off guard and had to catch up by rapidly raising official interest rates. This makes it difficult to manage inflation without causing a recession. In the United States, history shows us that every cycle of Federal Reserve rate tightening since the 1970s has led to some kind of recession. It is highly likely that central banks will have to take a break and ultimately won’t be able to tighten as much as the market originally expected.
With inflationary pressures likely to peak and growth slowing, the outlook for corporate earnings will be key in this next phase of markets. Equity analysts continue to predict higher earnings this year, but we’re not sure how that will be achieved, given cost pressures and the potential drop in demand. Companies took advantage of the tailwinds of a healthy US consumer and large amounts of cash in the system, which allowed volumes to increase and margins to expand. We can say that these tailwinds have now become headwinds. With pressure on the US consumer resulting in weaker sales growth and other factors – including anecdotal evidence of a resulting inventory glut – we expect weaker earnings going forward. Clearly some of this expectation is already in current prices, with stock markets down around 20% year-to-date, but we expect more negative price pressure as the benefits fade away.
What is the price ?
In credit markets where defaults have so far remained low, earnings pressure leading to higher default risk could widen spreads. That said, within the different credit markets, there is some dispersion as to what is taken into account. When we look at valuations based on our Rock Bottom Spread (RBS) metric (the equilibrium level of the spread for a particular default and recovery scenario), investment grade credit has moved to prices within ranges of recession type. In other words, if we enter a recession and default levels increase, investors are arguably compensated for potential losses due to default. That’s not to say spreads won’t widen, but at current levels, a mild recession is in the price.
High yield (HY) bonds, on the other hand, have not reached such an extreme. This means that if we enter a recession and default levels rise from very low levels, there are currently insufficient risk premiums for losses, given default. Part of the reason for this is compositional, as US energy companies make up a reasonable share of issuers in the HY Global Index and have performed very well, given high energy prices. In any case, we do not view high yield issuers as cheap and therefore have derivative positions which create negative net exposure (i.e. the Fund will benefit from further widening of spreads on the HY).
Over the past few months, we have continued to reduce exposure to credit assets, build liquidity and maintain low duration levels. We believe cash was preferable to credit, which is likely to widen spreads, and also preferable to duration-based assets, given the rising rate environment and rising bond yields impacting on capital values. More recently, we have increased duration exposure to take advantage of higher yields and also in response to growing recession risks. When sovereign yields were extremely low, the power of duration as a risk hedge was very weak – so we maintained very low levels. As yields rose and recession risks increased, we began to rebuild duration in the portfolio.
Liquidity equals flexibility
We continue to hold high levels of cash and short-term securities. The benefit is that the liquidity provides the flexibility to switch strategies as needed. We have seen liquidity evaporate in many markets, especially in credit. Therefore, having real liquidity in cash gives us an advantage when we want to redeem credit assets. Short-term cash yields rose significantly as the RBA raised official rates, with three-month bank bills yielding 1.91%, a significant increase from 0.08% in March.
Currency continues to hedge against downside risk as duration has been ineffective, but we hold minimal exposures. We exited our position in the Japanese yen earlier in the quarter and initiated a long position in the USD. We believe this will be a cleaner risk hedge against the yen which depreciated sharply as the Bank of Japan continued to control the yield curve.
Looking ahead, the upside is that term premia and credit risk premia are building up and we see opportunities to invest the significant cash we have accumulated. We have reinvested some of the cash in the Australian sovereign bond market, where we believe current yields are reasonably attractive. We will look to add more duration to the portfolio when we believe the risk/reward dynamic is moving more in our favour. On the credit side, we remain patient in the belief that recessionary risks have yet to be fully priced into the riskiest segments of the credit markets and that better entry points are likely. We remain focused on capital preservation and are alert to opportunities as they arise.
The Schroder Absolute Return Income Fund is an absolute return-focused strategy that has the flexibility to invest across the broad universe of fixed income securities. The Fund aims to outperform the RBA cash rate of 2.5% per year before medium-term costs.