An uncertain path forward

Market malaise

There is a lot of worry in global financial markets at the moment. Bond yields have backed up sharply, equities are gyrating and the energy crunch is intensifying. Natural gas prices have soared in Europe and a severe power shortage has shut down a big part of China's manufacturing activity - both will weigh on GDP growth. With global forces slowing growth while increasing inflation, policymakers are struggling to find a path forward. Central bankers almost everywhere are facing the same bad dream: a mix of slowing growth and inflationary supply shocks that together threaten stagflation. Ironically, some central banks may be happy to see higher inflation expectations after years of fighting deflation.

Long-dated Treasury bond yields have risen close to 40bps from early August. The trigger for the bond selloff has been more hawkish commentary from the US Federal Reserve (US Fed) and the Bank of England (BOE). The US Fed is likely to start to taper its asset purchases in November and the BOE looks set to hike interest rates this year. Central banks have been trying to distinguish between the tapering of bond purchases and interest rate hikes, but the market is interpreting these recent moves as the beginning of monetary tightening, bringing forward expectations of the first US rate hike to the end of 2022. The punchbowl of easy monetary policy is being pulled away, whether it be in the form of tapering or higher rates - and markets are naturally concerned.

Central bankers' dilemma

Global central banks face a delicate balancing act. Tighten too soon, and they could impair the recovery; tighten too late, and inflation could become entrenched. Responding to supply-side shocks with tighter monetary policy is extremely dangerous. The price spikes today are mostly caused by supply disruptions rather than excess demand. In fact, there are few signs of excess demand anywhere in the world. Supply disruptions, bottlenecks and long delays are akin to war-like conditions that cannot be cured by either monetary or fiscal policy. But keep in mind that relative price shocks are often self-correcting. For example, lumber prices have fallen 70% from the highs in May as high prices have destroyed demand and bought back more supply. Iron ore prices have recently collapsed as Chinese steel mills have been forced to cut back production because of power shortages and the huge jump in iron ore prices prior earlier in the year. Central banks understand they are dealing with a different type of inflation and have so far resisted acting, but the transitory shock is lasting longer than expected. The problem is supply constraints could take another year to resolve, allowing inflation expectations to rise.

In Australia, the RBA has time on its side - inflation is well below target and wages growth is weak. The RBA recently confirmed its current policy settings and reiterated that the conditions for policy tightening (actual inflation sustainably within the 2-3% range) will not be met before 2024. Given this dovish stance, the main directional driver of Australian interest rates will be the speed at which economic re-opening occurs and the growth impulse that creates. The RBA's optimism is in line with the broader consensus and should, along with their slow reduction in bond purchases, continue to exert upward pressure on longer maturity bond yields. Beyond that, the trajectory of global yields will be the major directional influence.

Bond yields rose notably in September, with the bulk of the move coming in the days after the Fed revealed an upcoming tapering of its asset purchases and revealed mildly upward revisions to its forward interest rate projections. Interestingly, some of the details of the bond market move don't mesh nicely with the mildly hawkish policy surprise that the Fed delivered. For example, the Treasury curve steepened on the month, instead of flattening and long-maturity inflation breakeven rates rose. This move has accelerated as energy prices have continued to surge. It seems that September's market moves were less driven by the Fed and more by a revival of the re-opening trade from earlier this year. Coming into September we were positioned for higher yields driven by the US but have been positioned for the flattening of curves which aligns with an ongoing stagflationary environment. We have since cut our curve flattening positioning looking for a continuation of the reflation theme into year-end as energy prices threaten further upside, potentially stoking further inflationary fears. We do however continue to hold a short position in inflation linked bonds in the US. We expect this will work well if the pace of inflation falls from lofty levels, or if the Fed becomes increases the pace of tightening.

Tapering is coming

Credit spread volatility remains very low in Australia while offshore markets have been more closely linked to rising concerns around inflation and fears that a potential default by China's Evergrande Group could impact stability of the Chinese banking system and property market. We have been tactically defensive since June but have since added to our exposure in Asian credit which offers standout value in the global fixed income opportunity set. We hold a derivative protection in US high yield, where valuations remain most stretched, alongside protecting the portfolio from further volatility in global credit markets. Our core position is in high quality Australian investment grade corporates which has been insulated from the offshore volatility and provides us with adequate spread compensation over government bonds. We remain invested in diversifying strategies such as Australian higher yielding, US securitised and emerging market debt.

It remains an uncertain environment with a lot of mixed signals and market influences. Recent volatility in rates and global credit markets are providing us with an opportunity to set the portfolio up more constructively. The economic data and policy developments have never been so important for the future direction of markets, we are watching this closely. Being active, diversified and flexible in our approach is paramount into year end.

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