The biggest opportunities we see today

As we look to the year ahead, we expect the impact of the global pandemic to recede and perhaps even surprise on the upside in terms of economic activity. Coupled with fast recovering consumer and business confidence, this should bode well for investors.

Within fixed interest markets, this is an environment that suggests bond yields will remain anchored or test slightly higher levels, and we believe there is little risk of materially lower yields from here. In this context, investors remain well-compensated for moving further along the relatively steep yield curve.

Inflation expectations are likely to continue to lift as economic activity gains momentum, with a gradual reduction in output gaps. A knock-on impact of declining output gaps is the potential for companies’ prospects and financial health to improve, which could see a flatter default cycle than first anticipated in the depths of the crisis.

The three biggest opportunities we see for fixed interest are active duration management as markets mis-price central bank activity, allocations to high and mid quality corporate debt and inflation protection.

In Australia, near-term risks are growing for certain industries that are exposed to the deteriorating China/Australia relationship. Longer-term, this has the potential to adversely affect Australia’s growth prospects.

Overall, our preferred approach would be to focus on the near-term recovery, along with the opportunities this presents for investors, whilst keeping an eye on the idiosyncratic risks.

Key themes that are particularly relevant

The big picture themes we see assisting fixed interest investments are a combination of coordinated policy activities. These include the Federal and State governments on the fiscal side, central banks with conventional and unconventional monetary policy, an easing in standards by the regulators and a pickup by the private sector.

In this environment, our north stars remain:

• Very low cash rates and risk-free yields for some time to come;
• Income bid – continued outperformance of spread products, such as credit; and,
• A shift from recession-proof portfolios to cyclical uplift, where longer-term sustainability is evident.

We feel this bodes well for investment grade and crossover (investment grade to sub-investment grade) corporate debt. Especially for those industries disproportionately hit by the pandemic but have however taken the necessary steps to develop and maintain sustainable business models.

Lessons from 2020

One of the biggest lessons of 2020 was that despite the nature of any shock, left field or otherwise, it’s important to detach economic outcomes, policy action, liquidity conditions and market pricing. The key being to back assessments of overshoots and to go early in acquiring mis-priced assets. Rarely do all the planets align in fixed interest investing.

One ‘chart to watch’ as a key indicator for change in 2021

The one chart to keep an eye on over 2021 is the output gap and how quickly this improves. This will be key in determining:

• Employment;
• Business investment;
• Income growth;
• Defaults receding; and
• Inflation.

These factors will ultimately drive asset prices including bond yields, inflation expectations, corporate debt outperformance and the total return of a well-diversified fixed interest investment.

Coupled with the greater than average opportunities available for active managers, this should bode well for active investors.

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