Markets were recovering as the US invited China to resume trade talks, only to come under pressure again as Trump threatened another round of tariffs which he duly delivered. The tariffs however, were somewhat less aggressive than expected. The US S&P 500 rose about 1.5% over the past four weeks as economic strength continued to carry the standout performer of the year. China also rose about 2.5% but remains nearly 25% lower than the recent peak in January. Japan’s Nikkei 225 rallied strongly, up over 6%, on the back of its leverage to global trade.
On the other hand, domestic troubles with the government that saw yet another Prime Minister come to power has led the S&P/ASX 200 lower by about 2% in the same period. The other negative performer over the past four weeks was the Euro Stoxx, down about 1%.
Bonds fell over the month as wage pressures in the US and risk-on sentiment led the US 10-year yield up nearly 0.2%, past the 3% mark again. The Australian 10-year yield also rose above 2.7%.
The Australian Dollar continues to struggle as it continues to trade around 72 US cents.
Trade tensions rose again as the Trump administration announced a new round of tariffs on Chinese imports. A tariff of between 5% and 10% of US$200 billion in goods will come into effect on 24 September, with the rate rising to 25% in 2019, and a threat of levying tariffs on another US$267 billion in imports if China retaliates, to which China has responded that it will slap tariffs on US$60 billion and take other measures.
Political issues continue to plague Australia as yet another Prime Minister was ousted and Malcolm Turnbull was replaced by Scott Morrison. The expectation is for more of the same with no real change in government direction, but the need to carry out an election by May 2019 has rattled investors. A Labour win would signal a big change in policy direction and holds many potential negatives for the market with the plans to change franking credits and negative gearing. Australian GDP for the year to June 2018 was better than expected at 3.4%, but this data is backward looking and more recent data has not been encouraging. House prices continue to fall which will undoubtedly affect consumer sentiment.
US economic activity indicators rebounded strongly following last month’s dip and US employment data remains robust. Wages in the US look to finally be rising, coming in at 2.9% for the year to August. This will be an important driver for the US Federal Reserve’s rate hike path and bond yields, given that inflation and employment have shown strength for well over a year.
European data remains benign as inflation remains at 2% with wages growing at about 1.9% while economic activity indicators continue to point toward decent growth. This has led to the European Central Bank announcing that it will continue with its Quantitative Easing program until the end of the year and is unlikely to raise rates until at least the middle of 2019.
Following the recent easing measures, Chinese activity indicators have stabilised but the additional tariffs coming into force means that a strong rebound is unlikely and further easing measures may be implemented in the coming weeks.
The uphill battle for traditional fixed income
The US 10-year bond yield is the most watched marker in the traditional fixed income space and has just pushed above 3% again. The past couple of years have not been kind to the traditional fixed income space, the 12 months to August 2018 provided a measly 0.8% for Australian hedged index exposure to the international fixed interest and the 12 months before that yielded another poor 1%, below the inflation rate. The domestic fixed interest index has not fared much better, with a 3.8% and -0.7% in the respective periods. The biggest headwind has been the environment of rising yields.
Since the 1980s, bond yields have only headed lower, giving rise to a long and powerful bull market in bonds that outpaced even the riskier equity markets. In the 30 years to October 2016 (the month that some have marked as the end of the bond bull market), the domestic fixed income index has returned 8.9% p.a., whilst the hedged international fixed interest index returned 9.4% p.a.. This was primarily due to the long grind lower in bond yields until October 2016, as the chart below shows.
Since then, yields have trended upward and despite the end of a synchronised period of growth in 2017, global yields are still likely to move higher as the US Federal Reserve raises rates and shrinks its massive balance sheet, with the European Central Bank expected to follow suit next year. Inflation has finally started to come through in the developed countries as well which could lead to further rate hikes. This does not bode well for traditional fixed income, but it remains an important part of diversification in portfolios and is still likely to show defensive characteristics during risk-off periods. However, with yields still low, investors are likely to be poorly compensated for holding traditional ‘safe’ bonds as the erosion of capital values offsets the coupons received.
This has led to a rise in the popularity of ‘alternative’ fixed income sources. With the increase in bank restrictions on lending since the Global Financial Crisis, there has been strong growth in the private lending space. As banks have been forced to retreat from lending to both individuals and corporates outside a strict set of rules, investors have rushed in to fill the space. The chart below shows how some of the large private equity investors have pivoted to private debt in recent years.
These ‘alternative’ fixed income sources often offer much more attractive yields than traditional bonds, and many have the benefit of being ‘securitised’ or asset-backed. Many of these are also on floating rate terms which means that the income received will rise in the rising yield environment. The danger with these is that the deals are generally done directly with the asset manager, hence the term private debt, and is not traded on the market like traditional bonds. This means that there is a lack of liquidity, similar to private equity, and manager skill is extremely important to ensure that risk is managed properly. One has to look back just 10 years ago to the Global Financial Crisis to see what could happen if excessive risk-taking occurs in the asset-backed securities space.
Overall, the ‘alternative’ fixed income space looks relatively attractive in the current fixed income environment, and whilst portfolios should maintain a position in traditional bonds for its diversification and defensive benefits, investors should also consider some ‘alternative’ fixed-income investments to improve returns.
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