Fixed Income

About-faces by central banks

Stuart Dear, Fund Manager, Fixed Income, explains that in a challenging return environment, we believe being positioned defensively but with flexibility to engage emerging opportunities is the appropriate strategy.


Stuart Dear

Stuart Dear

Deputy Head of Fixed Income

January saw the re-emergence of the two trends that dominated 2015: Chinese equity market volatility and falling oil prices. The Chinese equity market had a bad start to the year, falling by 7% in the first day of the year and ended January 23% lower. The fall reflected concerns about the Chinese economy unravelling with soft economic data, large capital outflows pushing the currency lower, and fears authorities are losing control. In the middle of the month oil prices became the dominant market factor, as West Texas Crude hit a low price of $26.19, the lowest level since 2003. This led to markets pricing in a greater risk of global deflation. Policy support was provided by the People's Bank of China (PBoC) and the Bank of Japan (BoJ). While the PBoC provided significant liquidity injections it was the BoJ’s actions that had the largest market impact. The BoJ surprised markets by announcing it was taking interest rates into negative territory, with a portion of bank reserves held at the central bank earning -0.1%.

It was one-way traffic for global bond markets in January as bond yields fell over the month. US 10 year government bond yields fell sharply, ending the quarter 0.35% lower at 1.92%, while 10 year government bond yields fell in Germany and Japan, by 0.30% and by 0.17% respectively. In Australia, 10 year government bond yields fell by 0.25% to 2.64%, in line with the global trend. The Reserve Bank of Australia doesn't meet in January and thus the official cash rate remained at 2%. Credit performed poorly in the month, with both global investment grade underperforming government bonds and high yield credit posting negative returns.

January was a rough month for risk assets triggered by renewed uncertainty about the pace of slowdown in China, further commodity price declines, and growing anxiety about the ability of the US economy to withstand rate hikes. Sovereign bonds rallied, led by US Treasuries, while credit assets, notably high yield, retreated. 

A month is a long time in central banking these days it seems. Within weeks of the Fed hiking, market turmoil and softer US data now have FOMC members watering down prospects for a steady pace of gradual tightening as flagged in December. The ECB lowered deposit rates (further into negative territory) and extended its buying program in December – disappointing expectations for an even stronger easing - but by mid-January felt compelled to flag further aggressive (“no limits to our potential policy options”) action. The BoJ’s Governor Kuroda wins January’s prize for the quickest turnaround however – in mid-January he was denying any intention to take rates negative then (following a quick trip to Davos that got the conspiracy theorists theorising) on January 29 he did exactly that.  

Such about-faces by central bankers are not new, especially in recent times as the apparent desensitisation of the real economy to monetary stimulus has meant that (at least the timing of) policy changes are highly sensitive to variations in financial conditions (i.e. market moves).  However, with a whiff of desperation – in the face of the ongoing low growth, low inflation environment - evident in January’s central bank developments, there are two important ways in which central banks are potentially contributing to instability: 1) policy divergence between the Fed and the rest is damaging a range of commodity producing and dollar-linked economies more so (at least in the short run) than the benefits of cheaper commodities and weaker currencies are accruing elsewhere and 2) easing central banks are engaged in competitive FX devaluation, redistributing (rather than generating) net global growth and likely motivating aggressive counteraction by others, thus dampening the initial competitive improvement.

While it’s fashionable to blame central bankers for the current malaise, the reality is being a central banker is a thankless task. Economies have changed (technology and globalisation have improved efficiencies leading to oversupply, higher debt loads and demographics suggest increased saving over investment), old policy frameworks (inflation targeting through regulating the short-term price of money) have hit limits, and the new policy framework has altered the near-term return-risk equation for a range of assets (as central banks have directly engaged in the market for some of those assets, and as related regulatory change has changed behaviour by private participants).

Market sensitivities are now (and have been for some time) very high to developments in China and the oil price. While this makes sense - China as the number two economy, largest employer and largest manufacturer, and oil as both a key input to global production as well as key component of household expenditure – a lack of transparency with respect to each reduces confidence, tightening the feedback loop between markets and policy. Our own outlook is distinctly cloudy.

However, while adjustments by central bankers to the new realities (including that policy may not be working) are generating uncertainty in markets, the maths of longer-term investment returns hasn’t changed. We remain in a low return world. A bond which yields 1% now will (in the absence of default) return only 1% pa over its life, though in the short term central bank actions may pull forward some of that return and potentially impose losses later. This is certainly true for the large part of the European fixed income market trading at negative yields. Negative rates have now extended both to Japan government bonds, and to pockets of the corporate universe.

The extended value proposition remains the key driver of positioning in our fixed income portfolios. Sovereign bonds remain expensive versus longer run fair value measures, and additionally there is evidence to suggest that at these low yield levels bonds may be losing some of their power to diversify risky assets. While cyclical risks may have shifted a little (primarily due to the sensitivity of the real economy to financial markets through both wealth and confidence effects), we have not materially altered our assessment of them. We consequently continue to run a duration position materially shorter (-1.40yrs) than the valuation-agnostic benchmark, with the short being roughly evenly distributed between Australia, Germany and the US. It’s important to note that most of our relative short duration position is due to the benchmark lengthening materially since the GFC.

We see valuations in credit now being slightly better than fair, with recession (which drives defaults) unlikely, though we remain cautious generally, especially given some deterioration in corporate fundamentals and in market liquidity conditions. At the start of February however we did tentatively increase our allocation back to both domestic and global investment grade credit given their improved valuations. Our preference remains for high quality shorter tenor bonds, though subordinated local bank paper and even some non-financial hybrids are now reasonably attractive. We 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 bonds, preferring cash, top-rated domestic RMBS and corporate exposures.

With a significant underweight to duration risk, only moderate credit exposure and high effective cash weight the Portfolio is well positioned to continue to provide defensive absolute outcomes, albeit that the cyclical and policy making uncertainty may impair short term relative returns. In a challenging return environment, we believe being positioned defensively but with flexibility to engage emerging opportunities is the appropriate strategy.

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