By Gibson Smith
Deflationary pressures are building in the world economy, especially with the plunging prices of crude oil and other commodities. China’s slowing growth has become a greater concern, as have the prospects of emerging market commodity producers. The “lower rates for longer” assumption has become a market consensus. But, don’t expect these lower rates without a significant amount of volatility.
Global growth uncertainty to keep volatility elevated
Diverging growth trajectories between the US, the eurozone and Japan have increased market volatility. Yet, economic tailwinds are gathering as central banks respond to global economic challenges with unprecedented monetary stimulus. Lower petrol and food prices are also tailwinds for consumers. However, any global economic recovery will likely be uneven as it unfolds because of different country dynamics. As a result, uncertainty about global growth should persist and keep market volatility elevated.
Lower liquidity and currency moves creating choppy market
Liquidity providers have reduced capital commitments to their bond trading business due to greater regulation, at a time when the overall size of the market has been growing. That has created less liquidity, making prices more vulnerable to short-term spikes and plunges. The stage could be set for more broad-based market volatility as divergent monetary policies of central banks may also create more turbulence in foreign exchange markets.
I think it’s important to be more defensive in one’s fixed income positioning at this juncture. With valuations stretched and yields low, there are risks that we have not seen in years. I also believe that avoiding large directional duration bets in the long end of the market can help limit exposure to volatility. A certain amount of Treasury exposure can be used to help buffer volatility of fixed income risk assets, like corporate credit. It is critical to first avoid the significant downside risk that long duration positioning courts while still sticking with a process that seeks out opportunities for investors to participate in the upside.
Volatility calls for active management
While Treasury market volatility has gathered increased attention, more attention needs to be paid to credit market volatility because it is creating downside risk.
Credit market volatility is being driven by several factors. Even though corporate credit spreads have widened over the last six months, we continue to have historically tight credit spreads. High valuations continue to make credit vulnerable to a sell-off. Given the uncertain global growth environment, many potential buyers of credit are not interested in adding to their positions which exacerbates low market liquidity.
As it stands, we’re now late in the credit cycle, marked by a significant increase in shareholder friendly activity, which is not bondholder friendly. Companies are re-leveraging their balance sheets through share repurchases, increased dividends and expensive acquisitions. It is now much more challenging to find attractive risk-adjusted returns in the credit market as it has priced in much of the corporate deleveraging that has occurred since 2008.
Amid low rates and lower price return potential, many investors are stretching for yield and returns by loading up on lower credit quality bonds and taking big positions in longer duration securities. We believe this foolishly courts downside risk, especially amid the market’s potential volatility. Patience and discipline are required not to take on excessive risk and to be more defensive in one’s positioning. As volatility increases and uncertainty takes centre stage, we want to be in the position to take advantage of others’ complacency and excessive risk taking.
Gibson Smith is CIO, fixed income & portfolio manager at Janus Capital
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