Vale to the days of lax rock-bottom monetary policy, the key driver of global markets and the duly feared (inverted) yield curve. As the pandemic arrived on the world’s doorstep in late-2019, it would go on to be the catalyst for some of the largest rate cuts seen by central bankers in recent history. As economic conditions worsened, a distinct and pronounced effort began to stimulate the world economy so as to build a sturdy “bridge” to the other side of the crisis. While the record stimulus has had its (mostly) desired effect of carrying markets and economies to the other side of the ‘valley of death’, the residual effects of central banker and government actions are now proving worrisome for markets.
Whilst the next Olympic Games are still two years away, many central banks are hard at work on their gymnastics routine, vigorously perfecting their backflip. Inflation had originally displayed transitory features, but this description was officially retired by US Federal Reserve (Fed) Chairman Powell in a December speech. Powell was not yet accepting defeat on inflation but instead clarifying the Fed’s forecast true nature of inflation.
Traditionally a dove (a central banker who emphasizes low rates, growth, unemployment as opposed to inflation control), Powell showed a new hawkish tone in the speech with other central bankers in the U.S gradually following suit, along with new projections of when rates would rise as per the Fed’s “Dot Plot” (a visual representation of the Fed board member’s individual forecasts). Broadly speaking, markets continually attempt to price in what the future holds with respect to inflation, economic growth, and corporate earnings. It is therefore said that market volatility in the short term is seen to reflect sentiment while in the long term, it is a reflection of fundamentals.
The hawkish backflip by Powell surprised markets from their priced-in expectations and saw long-end yields decrease whilst short-end yields increased. This was in the face of persisting inflation pressures partially spurred by the effects of the Omicron variant, knock-on issues in supply chains and stronger than expected employment reports. Since then, major central banks around the world have gradually revised their outlooks and forecasts to reflect higher rates in the future, most bar one, the Reserve Bank of Australia – leaving Governor Philip Lowe lonely in the dove’s corner. Even the European Central Banks’s (ECB) President Christine Lagarde noted that there were ‘serious concerns’ about the path of inflation which after Powell’s statement in December, was another shock to markets given Europe’s multi-speed recovery. This leaves Lowe as the only juror standing in the way of a potentially unanimous verdict.
How have we guided the Enhanced Income Trust (EIT-W) through this volatile period?
Accounting for the above, markets have seen a noticeable reversal in the outlook for inflation, growth, and jobs – the question is now whether inflation is sticky and will continue to rear its head or whether it will subside as pressures ease. Most importantly where does this leave us? Are markets correct and how are we positioned?
At the beginning of 2022, the interest rates market sold off (government bond yields increased) due to a combination of factors, namely the change in tone from central bankers and stickier inflation. This saw moves in tandem among developed market bond yields. While the latest Australian Consumer Price Index (CPI) numbers came in marginally higher than expected, it still remains significantly lower than US CPI. This suggests that the latest sell off in rates is part of a broader global macroeconomic theme rather than specific to Australia’s own inflation level. Our expectations are for Australia’s inflation rate to rise as contributions from strong household savings levels and global supply chain issues continue to filter through. Whilst there remains some uncertainty as to the future magnitude of these effects, we have multiple ‘levers’ and ‘tools’ to utilise in the management of EIT-W in the pursuit of its investment objective.
Inherent within EIT-W’s investment parameters, is a limit on the amount of ‘duration’ (interest rate risk) allowed in the portfolio. This ensures that the Trust’s sensitivity to movements in bond yields is limited to only 1 year at the portfolio level. This limit contributes to lower volatility and greater resilience during rising yield/rate environments. In anticipation of market conditions, we dynamically adjust the portfolio duration between 0 – 1 year as a means of adding additional performance to the Trust’s returns. Despite this ‘active’ positioning, the portfolio remains stable.
Currently, EIT-W’s level of duration sits at 0.8 years, with a continued preference for floating-rate securities which offer protection against rising and volatile yields. Due to the natural bias toward floating rate notes, EIT-W has weathered parts of the recent market volatility relatively well.
Whilst duration management allows us to manage the level of rate risk at a headline level, we further manage this risk by quantitatively analysing the yield curve to determine which part of the curve provides the best value in terms of ‘carry’ (income return) and ‘roll down’ (capital gain as bonds approach maturity). This analysis also allows us to view which part of the curve is most attractive for fixed-rate corporate credit and the desired positioning in the portfolio.
With respect to individual security selection (from corporate issuers), we utilise fundamental ratios specific to the issuer on both a broad credit basis and a sector-specific basis. The weighting of these ratios forms a broader credit score which allows us to compare one issue against others in the sector as well as on a cross sector basis. Utilising publicly available data for listed companies allows faster information flow than awaiting a review from a credit-rating agency which typically lags the market. The utilisation of this score enables us to view bonds as rich/cheap based on our view of creditworthiness which allows us to pick securities which are considered to be undervalued and avoid those which we deem as rich. Furthermore, additional considerations such as pricing power and competitive position also account for part of the investment decision. This is pertinent during times of rising rates and higher inflation. Specific to EIT-W, sector allocation has seen the portfolio placed in industries which are generally able to pass on increased costs to end consumers (such as real estate trusts or infrastructure) and benefit from higher interest rates (banks, residential mortgage-backed securities).
At U Ethical we acknowledge the stormy seas that fixed income investors have sailed through. Without doubt there are still some headwinds on the horizon, however our prevailing view is one of opportunity for income investors, which we are well poised to make the most of in coming months.
If you would like to know more about our fixed income products, please get in touch with our Client Service team at firstname.lastname@example.org