Jupiter´s Bezalel provides market commentary
For much of this year we have been at the more hawkish end of expectations on US rates, believing the market could be underestimating a potential pickup in growth in the domestic economy. We have recently modified our views on concern that the US economy is not immune to mounting external risks. As a result we have moved into capital preservation mode and have made a number of tactical changes to the fund. The following is a summary of the risks that have given us cause to change our view.
1) Geopolitical and deflationary risks
We believe the market has been complacent in the face of geopolitical risk and are worried by the relatively limited market reaction to heightened levels of global uncertainty across a number of regions (Syria, Iraq, Hong Kong and Russia/Ukraine), while the potential spread of Ebola is also of concern.
While we continue to monitor the risk of inflation in the longer term, especially if the job market tightens in the US, falling inflation has become a more acute near-term risk, in our view. This is reflected in a number of indicators: the sharp move lower in US “breakevens” (i.e. inflation expectations as calculated by comparing the yield of inflation-linked bonds and conventional Treasuries), the rally in the US dollar (which means lower domestic inflation as well as tighter global liquidity) and a marked decrease in commodity prices (which are a bellwether for demand in China and the global economy in general).
2) An evolving monetary policy backdrop
Fed tightening: how far, how fast? The outlook is less clear.
We remain of the view that tapering will cease as planned in October. However, it is now up for debate whether rates will rise in 2015 and we have become more aligned with the market’s expectation that interest rates will rise more steadily and will be data sensitive.
The current environment appears too fragile for a hawkish stance from the Fed and we believe further evidence of deflationary pressure could trigger more dovish comments from Chair Yellen.
The European Central Bank (ECB) is likely to move steadily towards outright quantitative easing, although we don’t expect the central bank to get there any time soon.
We are of the view that a weak euro buys some time for the ECB and that in the short-term the focus will be on implementing the asset backed securities and covered bond measures announced to date. Regional political divisions also remain a barrier to further monetary support.
The UK economy, while reasonably buoyant to date, may not be immune to eurozone weakness, given the importance of its exports to the region. While we still believe the Bank of England is nearer to tightening than any other major central bank, the timing of this is less certain. In addition, the prospect of Labour coming to power in 2015 could put downward pressure on sterling.
“Capital preservation mode”
In light of the above, we have made a number of tactical changes to the Fund and remain in capital preservation mode.
Responding to a less certain macro environment
In the US, we have cut the 5 year Treasury short position. Risks are now much less biased towards a second “taper tantrum” and we are more inclined to think that lower rates are here to stay for a while.
In Australia, we have increased our government bond allocation aggressively to about 22%, thereby building more caution into the portfolio. Compared to other sovereign bonds, Australia continues to look appealing in our view.
The overall duration of the portfolio has moved up by around two years to 4.5 years today.
We continue to hold a 10% long in the US dollar, which has worked well as a hedge against macro uncertainty.
Maintaining a cautious view on credit
Our overall view on credit remains cautious and we continue to be highly selective in this environment. We continue to focus on senior secured names and short-dated paper and have reduced exposure to higher beta areas of the market. CoCos, for example, now account for only c.1.5% of the fund, down from a high of roughly 5%. The overall allocation to high yield is around 60%, and we are expecting bond redemptions of around 10% of holdings over the next year and further bonds to be called, which will naturally reduce our allocation.
We have taken steps to mitigate the risk of a widening of spreads in the high yield market, through cheap insurance in the form of out-of-the-money put options on the iTraxx Crossover index.
We currently hold around a 5% allocation to cash, which reflects our concern that there is likely to be more volatility ahead for credit markets. We also hold what we consider to be near-cash investments, such as short-term sovereign bonds issued by Greece and Cyprus, and Thomas Cook’s 2015 bonds which yield some 3%.
We are still seeing selective opportunities within high yield and emerging markets and are also focused on identifying higher quality opportunities in government and investment grade credit markets.
At times like this, being able to take a dynamic “go-anywhere” approach can have its benefits, in our view, and we believe these tactical changes mean the Fund should be better positioned for turbulent conditions ahead.