Good news for credit investors despite the looming threat of recession
The last month has seen a rally in global bond markets, after a protracted period of repricing, US 10-year yields down around 32 points to 2.76% as of 9 August. This comes as several forward indicators have begun improving, as I explained in a recent sit-down with PIMCO’s Hugh Holden.
Some of the positive indicators include:
- A fall in the demand for goods, which has driven prices down,
- A correction in energy and commodity-related prices, and
- Signs of a softening US labour market, which could cap wage growth.
The market is now beginning to think about a potential peak in inflation and hence a peak in central bank hawkishness.
In the following interview, I explain how our portfolio positioning has shifted in line with these indicators. And while acknowledging the need for caution amid the rising probability of a recession, I also name a couple of opportunities including a well-known US firm’s A-grade corporate bond issuance.
Hugh Holden: Hello, I'm Hugh Holden and I'm joined today by portfolio manager Aaditya Thakur. And Aaditya, we've mentioned over the last few months that bond markets have repriced significantly. We've been reducing our underweights to duration, getting back to a more neutral stance in our portfolios, also encouraging clients to do so. And pleasingly, at least anecdotally, many of them have been beginning to do that. I guess also pleasingly we've seen bonds begin to rally over the last month. So what's caused that and what's next?
Aaditya Thakur: Yeah, sure. Let's start with inflation. Despite the more recent inflation prints still at eye popping levels, some of the forward looking indicators are improving. So we've seen a fall in the demand for goods and hence goods prices. We've seen a correction in energy and commodity related prices as well with oil now below $100 a barrel. And we've seen some signs of softening in the US labour market which may cap further wage growth.
So overall, the market's thinking about potentially a peak in inflation and hence a peak in central bank hawkishness.
Now on the growth side of the equation, we've seen a clear deterioration of growth around the world. That's reflected in business surveys like PMI’s, but also some of the consumption data as a lot of this rapid tightening is starting to be felt in the real economy.
So overall, this combination of some improvement on the inflation side, but a deterioration in growth, that's positive for bonds and that's why we continue to add duration, get back to more neutral positions to benchmark and also start thinking about yield curve steepening positions as recession probabilities rise.
Holden: Okay. And then I guess, speaking of recession probabilities, another question we've been receiving from clients is what does that mean for credit? If we do end up with a recession or at least slowing growth?
Thakur: Well, certainly with the move higher in yields and the widening of spreads, valuations for credit have improved significantly. But that said, as you mentioned, with recession probabilities rising, it's still a time to remain a bit cautious.
We still retain a bias to be up in the quality spectrum and retain liquidity in our portfolios. But we are seeing more and more interesting opportunities, more so in the primary markets.
So, for example, John Deere, which is an A-rated corporate, issued in Australia, a three year bond with a yield of 4.9%. And just a bit further down the credit spectrum, we've seen issuance by the Aussie major banks in tier two space in a low to mid 6% yield.
So I think in primary markets there are selective opportunities. But overall we still retain a little bit of caution as recession probabilities rise.
Holden: Well, thanks Aaditya. I guess a few key takeaways from that discussion.
If you are still underweight bonds or duration, think about continuing to move back to a more neutral stance. On the credit end of the spectrum, try to maintain an up in quality bias and focus on higher quality. And then finally, make sure that you're maintaining some liquidity in your portfolios.
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Aaditya is a senior vice president and portfolio manager focusing on Australian dollar and global portfolios. He has 13 years of investment experience and holds a master's degree in commerce (finance) from the UNSW. He is also a CFA charterholder.