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[FIXED INCOME] Looking through the volatility — thoughts on economies, markets and portfolio positioning

By James Blair

Financial markets—across most asset classes—have been volatile in the past two months, as investors grapple with further signs of slowing growth in emerging market economies and in China in particular. Commodity prices have been under pressure, equity markets have been weaker and very volatile, and credit spreads have generally widened globally. Given this backdrop—and the September Fed meeting where the market was steeled for the first hike in US rates this cycle that did not eventuate—it is perhaps surprising that government bond yields have not been particularly volatile. Indeed, despite the volatility in markets, Australian 10 year bond yields traded between 2.65 and 2.75% for much of August and September.

The divergence between the relatively robust performance of the US economy and sluggish growth in the rest of the world (both developed and emerging) continues to be a key strategy theme playing out. A related theme for financial markets is the path of commodities prices—the ongoing weakness across the entire commodity complex will contain inflation and will clearly lower the export earnings of commodity-producing economies. This also has implications for the (lower) future level of FX reserves held by many central banks and the knock-on implication of further selling pressure in major bond markets.

Weakness in Chinese growth—given the country's importance in the global economy—is concerning and has been one of the key factors driving the recent marked increase in market volatility. We believe Chinese policymakers will be forced to continue to adjust settings in what is a challenging and volatile market environment and we expect further CNY and interest rate policy adjustments in coming months.

Despite opting to keep rates on hold at their September meeting, the US Fed remain keen to begin the process of raising rates before the end of 2015—as long as domestic data and global factors do not deteriorate markedly in the interim. Through all the market machinations about the date for 'lift off', it is important to remember that the profile of future Fed Funds rates is far more important than the timing of the first move and in this regards, Fed Chair Yellen has been at pains to stress that the path higher will be gradual and data-dependent. In most other countries it is a case of monetary policy needing to remain highly accommodative. Indeed, in September we had further rate cuts from the central banks in Norway, NZ and Taiwan.

The data released on the Australian economy continues to point to sub-trend growth. Export volumes are increasing but the positive income impact is somewhat subdued by reduced export prices. Employment indicators remain firm but risks to the outlook for growth and the economy's potential growth remain skewed to the downside. The volatility emanating from weakening Chinese growth and the feedback loop from the declining terms-of-trade and loss of national income will continue to weigh on domestic growth.

However, there are a number of bright spots in the Australian outlook, namely housing, employment and service exports (with the latter a clear beneficiary from the lower currency). The recent change in the Prime Minister and his new Cabinet have had a positive near-term impact on consumer and business sentiment, as government commentary focuses more explicitly on targeting growth-enhancing measures; time will tell how much community (and Senate) support they actually have to enact these. Interest-rate and exchange-rate sensitive sectors have continued to benefit from the low cash rates and the new six-year low in the $A (a 10 year low if one excludes the GFC period).

The RBA continues to expect that this substantial shift lower in the currency, along with the hoped-for pick-up in non-resource related capex, will support their growth projections. That said, a weak external sector and ongoing domestic softness outside of the housing sector may ultimately push the RBA to cut rates in an attempt to further stimulate growth. In terms of rates strategy, with so much now priced into the front end of the curve (with close to 40bps of cuts in the coming 12 months already in the curve) we continue to look for opportunities to shorten portfolio duration on further rallies in yields.

The credit cycle is maturing and there is a greater divergence between regions, sectors and issuers and we are seeing markets requiring a greater compensation premium for liquidity and volatility risks. As is common as the credit cycle matures, idiosyncratic risks have been rising—with Glencore and VW clear recent examples of this. Australian credit markets have performed reasonably well in spite of the weakness experienced in US credit markets, with investor selling weighing on cross-over and high yield sectors. In contrast, Australian credit market fundamentals remain broadly supportive. We remain overweight shorter-duration corporate credit, but have progressively wound back this position over time.

James Blair is Head of Capabilities Management Asia Pacific for UBS.

DISCLAIMER: Whilst the information and statistics contained in this article are believed to be correct at the time of publishing, they are indicative only and do not constitute legal or financial advice. Investors should seek independent financial and legal advice before deciding whether any investment is right for them.

Published on: Wednesday, October 14, 2015

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