by Chris Dickman, Co-Founder and Senior Portfolio Manager, Altius Asset Management
World markets have become accustomed to the security blanket of Central Bank asset purchase programs, or quantitative easing (QE), in recent years. That led to ultra-low cash rates, and low yields and lower volatility in all asset classes.
Now, in the wake of economic growth acceleration, central banks are unwinding their QE programs and risk-free rates are being unshackled.
In Europe, economies are registering higher growth and lower unemployment levels while in the US, the markets have reacted to stronger wages growth within non-farm payrolls.
But inflation is still not high enough for the European Central Bank to modify cash rates, given that inflation targets are their only mandate and the current rate of inflation remains below the target.
In recent years, the Chinese central bank (the People’s Bank of China) has been a major purchaser of US Treasuries, but the unwinding of the US Federal Reserve balance sheet is expected to outweigh Chinese foreign exchange reserve buying.
As QE is removed, we will see a repricing of the global risk-free rate, leading to a repricing of all asset classes.
Equities will re-price as the risk-free rate re-prices. Only companies generating strong earnings are expected to maintain value, and index weights do not account for forward earnings growth, with investors exposed to stocks under earnings pressure.
In this context, active management will be a better value proposition than index investing in responding to higher volatility across all asset classes.
With the unwinding of central bank QE, it is reasonable to expect asset prices to gyrate in a wider range and yields of all classes to lift.
This is just the start of a return to a higher, albeit more normal, market volatility. Markets have not seen this level of volatility since QE began 10 years ago and are likely to react accordingly.
As global bond yields rise, they will drag long-dated Australian yields higher; the 10-year US Treasury rate remains the biggest influence on the long-end of our yield curve.
But low inflation will underpin stable cash rates in Australia, allowing short-dated bonds to perform relatively well. These two scenarios will see the yield curve steepen, resulting in capital losses in long-dated bonds.
In Australia, inflation is being restrained, despite the continued rising cost of utilities, transport, education and health, caused by rapid population growth.
Australia’s population has increased by around two million people over the past five years, but an expanding workforce and weak consumer demand has helped to contain growth in both domestic wages and middle-class incomes.
Economic activity has essentially been driven by infrastructure and housing, not a rise in middle-class incomes, which propel business investment.
In the context of increased volatility, investors will need to be wary of allocating to cash or term deposits and to index or benchmark-relative funds.
The Altius Bond Fund’s style considers a whole-of-cycle approach without constraints on fund management, allowing the fund to be nimble and focus on elements of the bond market where there is opportunity.
In January, for example, the Altius Bond Fund generated a positive 0.5 per cent return in absolute terms, outperforming the Composite Bond Index, which recorded a negative return of 0.27 per cent.
Australian cash rates are likely to stay at 1.5 per cent for all of 2018, keeping term deposits low.
With a steepening yield curve, long-dated bonds will experience heavy losses. Benchmark-relative and index funds will be under pressure, given their heavy exposure to loss-making parts of the curve.
That’s why the Altius bond portfolio is favouring the two to three-year part of the yield curve.
Finally, the global economic backdrop – the reason QE is being unwound – provides opportunities in credit, but care will need to be exercised as asset classes re-price.