January 2016
The Fix
Defensive outcomes developing
opportunities
Stuart Dear, Fund Manager, Fixed Income
It was a rough year for markets as policy divergence in the West and slowdown in China drove USD strength,
commodity price weakness and emerging economy instability. Sovereign bond yields ended little changed, but
(especially longer tenor and riskier) credit weakened on default concerns in the energy sector and heavy
supply, while EM debt suffered capital flight. Apparent stability in standard volatility measures (such as VIX
and MOVE) belied the increased choppiness in markets compared to the prior several years during which
global policy broadly moved in the same direction. In 2015, there was uncertainty around if/when the Fed
would begin to raise rates. Distortions generated by ECB policy implementation, several currency policy uturns (e.g. Switzerland, China), concern over reserve de-accumulation, and diminished liquidity as a result of
increased regulation were all sources of unease in markets. This had previously ridden policy accommodation
to expensive valuations in virtually every asset class.
Fundamentally, the continued weakness in oil and other commodity prices was undoubtedly the major story. In
addition to supply side aspects (the big ramp up in capacity at higher costs of production, and the geopolitics
of OPEC’s production decisions), softer commodities reflected weakening demand across emerging
economies, compounded by ongoing sluggishness in developed market industrial production and capital
expenditure. With consumption reasonably well supported by employment gains in the service sector,
however, developed economy activity held about steady at near trend growth rates. Inflation, meanwhile,
moved lower on headline metrics in developed economies, and remained subdued on core measures, while
within emerging economies it varied greatly depending on currency moves.
Starting from expensive valuations, our valuation driven approach has seen us run considerably less duration
than the ‘expensive’ benchmark through the year, though with yields roughly going sideways this has been a
frustrating experience. Our approach has meant we’ve been earning less income than the benchmark but with
considerably less capital variability and greater liquidity. A more tactical trading approach may have been able
to capture some value, though this is questionable given the choppiness of the environment. In credit our
approach has been cautious in an absolute sense, but an overweighting versus the government-heavy
benchmark has cost us. In absolute terms we’d argue that better fixed income portfolios are more diversified
than the benchmark.
We enter 2016 facing similar challenges. While markets have rebalanced this year, most of it has been
between countries – via shifts in exchange rates, incomes (courtesy of commodity moves) and stores of
wealth (reserves). In aggregate, the mediocre-growth, low (real economy) inflation environment hasn’t
changed materially through the course of the year however our central expectation is that economies
ultimately step back towards normal conditions and rates of return on investments are more closely linked to
those economic outcomes. Sovereign bonds remain expensive versus even conservative estimates of
normalcy, implying both low future returns and a high probability of loss, and notwithstanding that some value
that has been created in riskier assets through market moves over the year, the overall prospects for fixed
income markets remain challenging.
In an uncertain world where the risks are always numerous, one of the key things we are watching is US
inflation. Our analysis of US inflation suggests a broadly benign, but rising trend in core US inflation in 2016 on
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The Fix: January 2016
the back of labour market tightness and a pass through of the oil price shock and USD strength. However, a
pick-up in the pace of inflation would cause a reassessment of the market’s current ‘patient Fed’ view and
potentially be the catalyst for the asset repricing - of both bonds and riskier assets - that our medium term
return estimates anticipate. Policymakers in the West and East face an enormous challenge to engineer
smooth economic transitions in challenging cyclical conditions and in light of persistent structural imbalances.
We continue to run a duration position materially shorter (-1.40yrs) than the valuation-agnostic benchmark.
While valuations are expensive everywhere, we’ve run most of the short in the US owing to the relative
outperformance of the US economy and proximity of Fed tightening, and held smaller shorts in Australia and
Germany on valuation grounds. We’ve been broadly correct in our relative country positioning as Treasuries
have underperformed, and have begun to rebalance our short exposure more evenly geographically.
However, the aggregate duration position is unlikely to change meaningfully until we see yields materially
higher, or the cyclical outlook takes a significant turn for the worse.
We see valuations in credit being about fair, with recession (which drives defaults) unlikely, though we remain
cautious generally, especially given some deterioration in corporate fundamentals and in market liquidity
conditions. Our preference remains for high quality shorter tenor bonds, though subordinated local bank paper
and even some non-financial hybrids are beginning to look attractive. We also continue to run a collective
underweight position to the non-credit spread sectors (i.e. semis and supras) given the modest additional
return they offer versus government, preferring cash, top-rated domestic RMBS and corporate exposures.
Preserving capital as markets adjust is a priority; 2015 has made it clear that patience is required. Effective
cash remains above 25% and the Strategy is well positioned to continue to provide defensive absolute
outcomes as well as being able to take advantage of the developing opportunities.
Important Information:
Opinions, estimates and projections in this article constitute the current judgement of the author as of the date of this article. They do not necessarily reflect
the opinions of Schroder Investment Management Australia Limited, ABN 22 000 443 274, AFS Licence 226473 ("Schroders") or any member of the
Schroders Group and are subject to change without notice. In preparing this document, we have relied upon and assumed, without independent verification,
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