Markets priced for perfection in an imperfect world

Market focus can move quickly. The concerns of 2019 now seem in the distant past. Brexit – resolved; trade wars – apparently resolved; central banks providing liquidity – unquestioned. They have been replaced by a focus on Iranian missile strikes and the coronavirus, among other issues. Despite some volatility early in 2020, by and large the market is viewing these new issues as noise. Risk assets continue to price in much of the good news while discounting the potential downside. Meanwhile, bonds continue to price in continued central bank liquidity. And so the equities–bonds divergence continues.

Relaxed and comfortable – or just complacent?

At the moment, the macro outlook would not be considered dire, with recession risks seemingly reduced – at least in the near term– while the overall risk to growth and inflation appears to be reasonably balanced. However, in our view, current valuations warrant caution, especially in an uncertain environment.

The coronavirus highlights this challenge. As this stage the market looks somewhat complacent. Many investors are assuming a SARS-type path, and hence feel somewhat comfortable that they understand what will happen. This may be the result, but the truth at this stage is that we don’t know the outcome – and the range of potential outcomes can be very broad. I am sure there are many new experts with “Google search degrees” in virology. I don’t profess to know how it will play out. What I can be more sure of is that the starting point for valuations of many assets appears stretched, with little room for error should the virus or another issue jolt risk assets. As such, we have entered 2020 with a defensive positioning.

Buyer beware in the hunt for yield

Overall the landscape has not become any easier for investors, especially those seeking income. Low cash rates persist and the search for yield continues to drive some investors to seek out products that are potentially further along the risk spectrum. The structured credit boom that cumulated in the GFC was driven at least in part by a similar search for yield when risk premiums were low.

I am not suggesting we are on the verge of a GFC and I haven’t seen the rise of structured products that occurred before. However, I have seen a proliferation of listed and unlisted products that are offering high yields. “Buyer beware” remains a useful mantra as we make investments and construct portfolios that seek to deliver income with an appropriate amount of risk. Given there is no free lunch in financial markets, a higher yield often brings higher risks.

Our portfolio position

So how are we approaching portfolio construction in the current market, given our absolute return focus? In short, we are defensive, diversified and liquid, given high valuations and continued uncertainty around the future path of markets. In the low yield world, we continue to look to sensibly balance income generation with efficient risk management and look for ways to effectively diversify both income and risk sources.

As such, the credit allocations in the portfolio remain defensive and we retain a focus on delivering alpha and not simply holding static beta allocations. We prefer Australian investment grade credit, which provides access to high quality income. Having trimmed our allocation to US investment grade credit as we reduced risk, we still retain an exposure which provides access to additional sectors not featured in Australia. We continue to hold emerging market debt and have also recently made an allocation to US securitised debt, as these allocations help diversify traditional interest rate and corporate credit risk. We also are exploring several other opportunities to further diversify our credit exposures.

In interest rates, we added to our long duration position as the news around the coronavirus was breaking. We took it from 0.9 years at the beginning of the month to 1.3 years currently. We continue to hold most of our duration in the US and are looking to add more duration in the near term.

Our currency lever continues to be important. Concerns around the effect of the coronavirus on the Australian economy pushed the AUD lower against the USD, so our long USD position both added to portfolio performance and demonstrated the diversifying role it can play in managing downside risk.

Overall the portfolio retains its higher-quality focus, though we are seeking additional new sources of return and diversification. We believe we are well positioned for a more challenging 2020 return environment and expect absolute return fixed income to continue to be a valuable portfolio holding in this environment. 

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