Consensus has embraced the notion that the global economy is now a very different structural environment. But do realities test this very persuasive thematic?
Higher for longer? Be careful what you wish for…
The global economy is highly indebted and financialised, and higher interest rates do matter.
The enlarged “financial economy” won’t enjoy adjusting to a higher cost of capital world. For growth to remain resilient, we believe the global economy will require lower interest rates.
Brave new "fiscal" world? If only it were that simple...
Ongoing use of fiscal policy is the new reality, who will fund this?
With government deficits already considerable – and in a world with fewer buyers of US Treasuries – the risk of long-end bond volatility and higher yields is increasing. While timing is uncertain, more liquidity seems inevitable.
The evidence suggests global economic growth has softened and requires more fiscal expansion and lower interest rates (likely both) to avoid the risk of further slowing ahead."
Brett Lewthwaite
CIO and Head of Fixed Income
- Economic downside risk remains elevated, and as such we see value in a more defensive positioning given the balance of risks.
- For the time being, we prefer to stay liquid, stay longer duration, and remain patient for better entry levels in credit markets.
- While we are wary of the inevitable greater use of fiscal policy and its increasingly concerning impact on government financing, as well as its potential to create stickier inflation, we sense the sequence is bond yields down first, with perhaps greater bond yield curve volatility.
As inflation has come down meaningfully from its peak and interest rates remain in restrictive territory, we remain longer duration and utilise it as our main lever to express our defensiveness - which could prove advantageous as the softening economic trend continues.
Risk markets have benefited from a benign environment. Corporate fundamentals are softening but are still in a strong position. In credit markets, technical support also persists with high demand from all-in yield buyers. This mildly positive outlook has seen credit spreads move to markedly tight levels, with only select pockets of value available. Hence, we are neutral.
We remain constructive on cash, given that there is a heightened importance to maintain elevated levels of liquidity to invest in opportunities as they arise when volatility subsides.
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Fixed income securities are subject to credit risk, which is the risk of loss of principal or loss of a financial reward stemming from a borrower’s failure to repay a loan or otherwise meet a contractual obligation. Credit risk arises whenever a borrower expects to use future cash flows to pay a current debt. Investors are compensated for assuming credit risk by way of interest payments from the borrower or issuer of a debt obligation. Credit risk is closely tied to the potential return of an investment, the most notable being that the yields on bonds correlate strongly to their perceived credit risk.
Fixed income securities are also subject to interest rate risk, which is the risk that the prices of fixed income securities will increase as interest rates fall and decrease as interest rates rise. Interest rate changes are influenced by a number of factors, such as government policy, monetary policy, inflation expectations, and the supply and demand of securities. Fixed income securities with longer maturities or duration generally are more sensitive to interest rate changes.
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Credit risk is the risk of loss of principal or loss of a financial reward stemming from a borrower’s failure to repay a loan or otherwise meet a contractual obligation. Credit risk arises whenever a borrower expects to use future cash flows to pay a current debt. Investors are compensated for assuming credit risk by way of interest payments from the borrower or issuer of a debt obligation. Credit risk is closely tied to the potential return of an investment, the most notable being that the yields on bonds correlate strongly to their perceived credit risk.
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Liquidity risk is the possibility that securities cannot be readily sold within seven days at approximately the price at which a fund has valued them.
Market risk is the risk that all or a majority of the securities in a certain market – like the stock market or bond market – will decline in value because of factors such as adverse political or economic conditions, future expectations, investor confidence, or heavy institutional selling.
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Inflation is the rate at which the general level of prices for goods and services is rising, and, subsequently, purchasing power is falling. Central banks attempt to stop severe inflation, along with severe deflation, in an attempt to keep the excessive growth of prices to a minimum.
Liquidity risk is the possibility that securities cannot be readily sold within seven days at approximately the price at which a fund has valued them.
Additional Tier 1 (AT1) Bonds serve as capital instruments that banks utilize to augment their core equity base. Unlike conventional bonds, AT1 Bonds are perpetual and thus, the investors are not paid the principal amount.
Duration measures a bond’s sensitivity to interest rates, by indicating the approximate percentage of change in a bond or bond fund’s price given a 1% change in interest rates.
Inflation is the rate at which the general level of prices for goods and services is rising, and, subsequently, purchasing power is falling. Central banks attempt to stop severe inflation, along with severe deflation, in an attempt to keep the excessive growth of prices to a minimum.
A Treasury yield refers to the effective yearly interest rate the US government pays on money it borrows to raise capital through selling Treasury bonds, also referred to as Treasury notes or Treasury bills depending on maturity length.
The yield curve is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity dates. The most frequently reported yield curve compares the 3-month, 2-year, 5-year, and 30-year US Treasury debt. This yield curve is used as a benchmark for other debt in the market, such as mortgage rates or bank lending rates. It is also used to predict changes in economic output and growth.
The shape of the yield curve is closely scrutinized because it helps to give an idea of future interest rate change and economic activity. There are three main types of yield curve shapes: normal, inverted and flat (or humped). A normal yield curve is one in which longer maturity bonds have a higher yield compared to shorter-term bonds due to the risks associated with time. An inverted yield curve is one in which the shorter-term yields are higher than the longer-term yields, which can be a sign of upcoming recession. A flat (or humped) yield curve is one in which the shorter- and longer-term yields are very close to each other, which is also a predictor of an economic transition. The slope of the yield curve is also seen as important: the greater the slope, the greater the gap between short- and long-term rates.
Yield curve inversion is when coupon payments on shorter-term Treasury bonds exceed the interest paid on longer-term bonds.
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