What does inflation mean for fixed income portfolios?

Brett Lewthwaite, Senior Managing Director, CIO, and Global Head of Fixed Income, Macquarie Asset Management

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2022 has finally seen a surge in inflation across developed countries and the big question now is whether this is structural or more transitory. In this episode, we chat with Brett Lewthwaite, Senior Managing Director, Chief Investment Officer, and Global Head of Fixed Income at Macquarie Asset Management, to discuss supply shocks, the changing role of central banks and what it all means for bond markets and fixed income portfolio positioning.

Disclaimer:

Macquarie Investment Management Australia Limited (ABN 55 092 552 611 AFSL 238321) is the issuer and responsible entity of the Funds referred to in this podcast. This is general information only and does not take account of investment objectives, financial situation or needs of any person. It should not be relied upon in determining whether to invest in the Funds. In deciding whether to acquire or continue to hold an investment in a Fund, an investor should consider the Fund's product disclosure statement. The product disclosure statements are available on the Macquarie website at macquarieim.com/pds or by contacting Macquarie on 1800 814 523. Please review the Target Market Determination for the Fund available at macquarieim.com/TMD and consider if the Fund may be suitable for you.  This information is intended for recipients in Australia only.

Other than Macquarie Bank Limited ABN 46 008 583 542 (“Macquarie Bank”), any Macquarie Group entity noted in this recording is not an authorised deposit-taking institution for the purposes of the Banking Act 1959 (Commonwealth of Australia). The obligations of these other Macquarie Group entities do not represent deposits or other liabilities of Macquarie Bank. Macquarie Bank does not guarantee or otherwise provide assurance in respect of the obligations of these other Macquarie Group entities. In addition, if this recording relates to an investment, (a) the investor is subject to investment risk including possible delays in repayment and loss of income and principal invested and (b) none of Macquarie Bank or any other Macquarie Group entity guarantees any particular rate of return on or the performance of the investment, nor do they guarantee repayment of capital in respect of the investment.

 

Transcript

Paul O’Connor:

Welcome to the Netwealth Investment podcast series. My name is Paul O'Connor and I'm the head of investment management and research. Today, we welcome Brett Lewthwaite from Macquarie Asset Management, who is the chief investment officer and global head of fixed income for Macquarie, based in Sydney. Good morning Brett, and great to have you as a guest for today's podcast.

Brett Lewthwaite:

Thank you, Paul. Great to be here. Really looking forward to today's discussion.

Paul O’Connor:

The Macquarie Asset Management business is one of the operating divisions of the ASX listed Macquarie group. Macquarie is a multi-disciplined asset manager, managing assets across fixed income, Australian equities and property. As of September, 2021, Macquarie managed over AUD 700 billion globally and around 228 billion in fixed income and currency. The Macquarie Fixed Income team is structured along specialist divisions, covering credit, sector location, global fixed interest, currency, domestic fixed interest and cash. Macquarie's credit team employs 16 analysts, with two located in Sydney, one in London and the remainder in Philadelphia. Macquarie has 19 additional analysts in Philadelphia covering municipal bonds, private placements, emerging market debt and structured products. The emerging market spec team of nine is New York based with three of the team based in Europe. So I would daresay Brett, there's no shortage of analysts and input across all of the sub-sectors of fixed income at your disposal there, to manage the portfolios.

Paul O’Connor:

Brett is responsible for Macquarie's fixed incomes, cash, credit, fixed interest and currency portfolios. His primary investment and portfolio management focus is on global and multi-sector fixed income portfolios. And he's been the lead portfolio manager of the long successful Macquarie Income Opportunity Strategy that was launched in 2004. Additionally, Brett serves on the Macquarie Asset Management Public Investments Executive Committee. Prior to his role as global CIO and head of fixed income, he led the fixed income teams in Sydney and London, becoming a senior credit portfolio manager back in 2004. Brett has more than 25 years of experience in financial services, and prior to joining Macquarie in 2003, worked as a portfolio manager at BT Funds Management for nine years. Brett holds a postgraduate degree in applied finance and investment from the Securities Institute of Australia, as well as a bachelor of agricultural economics from the University of Sydney.

Paul O’Connor:

There are nine Macquarie funds on the Netwealth super and IDPS Investment menus, including the Income Opportunities Fund and Dynamic Bond Fund that is managed by the fixed income team.

Paul O’Connor:

So 2022 has finally seen a surge in inflation across developed countries, and I guess the big question now is whether this is structural or more transitory in nature. The argument that inflation is structural is really based on the fact that years of extraordinary monetary policy, including quantitative easing, would eventually lead to inflation. And I guess some could argue this is supported by the recent spikes in GDP growth, both in Australia and offshore. The counter argument, that current inflation is transitory, I guess, is based on the view that supply chain shortages over the last two years have driven up costs, in addition to the surge in economic activity, since most economies have reopened post the COVID induced lockdowns.

Paul O’Connor:

Recently, we've finally seen central banks move to increase the cash rate in response to surging inflation numbers, as evidenced by the RBA, the US Fed Reserve, and even the Reserve Bank of New Zealand, all lifting their cash rates.

Paul O’Connor:

So in many ways, this should be positively viewed, given inflation has been benign for so many years and cash rates have been sitting at all time, historical lows. But with the Ukraine war, China's COVID lockdowns and the rise of geopolitical tensions globally, will these issues result in slowing global GDP growth that will then naturally bring inflation under control? So I'll be interested, Brett, in discussing your views on these issues, and also particularly how an active fixed income manager is positioning portfolios to deal with these challenges.

Paul O’Connor:

So maybe to start with, I ask most guests on the Portfolio Construction podcast, can you provide the listeners with a few comments maybe, on your career journey and how you came to be the CIO of Macquarie Asset Management with a career specialising in fixed income markets?

Brett Lewthwaite:

Yeah. Well, thank you, Paul. Thank you for that very nice introduction as well.

Brett Lewthwaite:

Yeah. I mean, how did I become the CIO of Macquarie Asset Management's Fixed Income group is an interesting question. And I think back over my career and sometimes wonder how I ended up in fixed income. And I don't think people necessarily intentionally end up in fixed income, but I guess back in the 1990s as a much younger person, I was thrilled actually, to be in financial markets, and at the time working at Bankers Trust. There were some very good people there. I think I would've been interested in all forms of portfolio management. It just so happens that I did a bit of quantitative skill, I guess, ended up in fixed income.

Brett Lewthwaite:

Interestingly, through time, I think my mindset was, financial markets are so dynamic, there's so much to learn, to some degree feeling quite out of my depth, I really just went about trying to do as much work and as much research as I possibly could, concerned that as I realised the difficult job that being a portfolio manager is, that actually being a good one might actually be a challenge. And I think gradually through time, and it sort of creeps up on you, you start to develop performance and a track record, that in and of itself, I think, is quite challenging. But then as clients start to recognise it and they start to appoint you as their manager, I guess the burden and focus really goes up.

Brett Lewthwaite:

And throughout my career, whether it was through the financial crisis, through to today, I think most of the time I've really just spent telling people what I think and what we think is generally coming from a lot of work. Those views haven't always been gentle on the ear. They haven't always been things that people want to hear, but we've always said it like we saw it. And I think through time that reputation has grown, and combining it with that sense of the burden or responsibility of managing other people's money, and now billions of dollars of other people's money, always just led to a high standard focus around what we were doing.

Brett Lewthwaite:

As things went along, as the environment continued to evolve, as clients recognised that more and more, I guess my seniority rose up and I guess thinking about it, it's probably the first time I've been asked that question, how did I become CIO? But it was really that cycle of hard work, burden focused responsibility, saying it like we see it, and getting those outcomes, which have led to that broader recognition within the organisation, but even more broadly than that. So it's been quite the journey and I pinch myself regularly about it. It's been fantastic.

Paul O’Connor:

No doubt, there's been a lot of hard work involved from yourself there, but I must admit too, as I've got older and spent longer and longer in markets, my view's been that I think fixed interest managers probably have the most challenging task because not only do they need to have a top down view and positioning on global economies and GDP growth, but then they've got to do the bottom up analysis then on the securities or the bonds that they're actually purchasing there too. So I think it certainly takes a broad skill set to manage fixed income portfolios. And as you say, a lot of hard work and doesn't happen overnight.

Paul O’Connor:

Moving into the major topic and questions we want to go through today, let's start with inflation. It's the major topic I think on everyone's minds at the moment, but what's your take on the prevailing situation, and do you believe it's supply-driven, demand-driven or really a combination of both?

Brett Lewthwaite:

It's interesting, Paul, it's only an hour or so ago, I came from our strategic forum for May. We do big deep dives three times a year, January, May and September. And we did our first session of the May one from 6:00 AM this morning. And so this is pretty fresh, in terms of thinking about inflation, the work and the deep dives that we've been doing. We largely see it as supply-driven. That's not to say that demand, perhaps hasn't been playing a role, when you think about the environment that we've been in, the effects of COVID, there is definitely elements there. But the majority of it appears to be supply-challenged. And it's probably played out in three components. And I think understanding each of those components helps understand that discussion around transitory or perhaps more structural.

Brett Lewthwaite:

The first phase where everyone was of the view that inflation was transitory, I think to some degree, that was the by-product of that COVID environment that we experienced. So never before have you seen a sudden stop so significant that we saw in March of 2020. But then as the pandemic progressed, each and every country, each and every city within countries even, adopted different approaches, either to lockdowns, to stimulating economies, to trying to keep people employed, even to vaccination rollouts. And so what we ended up with is a sudden stop and then a very uneven, out of sync, global recovery, that widely publicised disruption to supply chains. And so as we entered 2022, and there was, I guess, some hope that those supply disruptions, that being out of sync, would resolve itself as the pandemic moved to the endemic phase. I think most people, including ourselves, felt that 2022 would start to see inflation come off. And perhaps that comment around transitory, even though it was more persistent would start to play out as supply came back online.

Brett Lewthwaite:

But even back in January when we were having those discussions, and we could see that in the detail, we realised there was a period of vulnerability between when that data might start to show supply coming back online and inflation starting to dissipate, would be a period of months, perhaps even six to nine months. And that was a period where other things could happen. And as we all know now, there's been further disruptions out there. The first and most notable one is the war in Ukraine. And that has created a widespread, genuine supply shock of commodities, so not just oil, many metals, energy components, and also food. And that's a significant supply shock that's taking place, that genuinely looks like shortages of needs and has created that second impulse around inflation.

Brett Lewthwaite:

And just as we're having this discussion too, our friend COVID has returned to haunt us a little bit further with China's COVID zero policy leading to further lockdowns in places like Shanghai, Shanghai being a significant port for exports. Again, almost doubling down on those supply disruptions that we saw in the first round.

Brett Lewthwaite:

And so it's those three things, the one in the middle being the war with Russia and Ukraine and all that Russian energy and Russian Ukrainian, I guess, food exports, that are really responsible for the inflation pulse that we're experiencing at the moment. And that's how we are seeing it. There's definitely elements in the demand side of things as we recover from COVID. But the real challenge is that we've come from a place where it was very, very difficult to create demand. We've had a pandemic, and whether it's a by-product, both in terms of the way things have recovered, but also in geopolitics, the by-product is now this supply shock that we're enduring, creating that inflation pulse and creating a very challenging environment for central banks and perhaps financial markets.

Paul O’Connor:

It's understandable. And I mean, the surge in both hard and soft commodity prices in recent months has been quite extraordinary, I think. And Australia has been a beneficiary, I guess, out of that as well, due to the tragedy of what's going on in the Ukraine at the moment. But interesting comments you make there, Brett.

Paul O’Connor:

You've spoken many times about interest rates being lower for longer, and the challenge of creating inflation in a structurally challenged environment, so what do you think now?

Brett Lewthwaite:

Yeah, it's a great question, and it's a question I'm sure I'm going to be asked many times in the coming months because you're right, I have spoken loudly about lower for longer, and pushed against many of those elusive return to normal arguments that have occurred over the last 12 to 14 years. And right here, right now, I guess that concept of lower for longer is really being tested. If I can break this into a couple of components, the first one is what was causing lower for longer. And the second bit is well what's occurring now, and does that change things or not? And I think it's important if we can try and split those two.

Brett Lewthwaite:

I mean, lower for longer was really around a challenge in creating demand, and the structural forces that were weighing on higher levels of economic growth and depressing things like inflation was widespread indebtedness, demographic challenges, acceleration of digitalization, elements of early de-globalisation and also this significant dependency on central bank support.

Brett Lewthwaite:

So ever since the financial crisis, the thing that will probably surprise many people, but isn't often talked about, is that throughout that entire period, net net, the collection of all central banks, they have been adding quantitative easing or liquidity to the system the entire time. So ever since the financial crisis, we haven't had a situation where markets haven't been benefiting from liquidity injections. Now, at times there've been enormous injections and other times there've been less so. But that ongoing need for liquidity support and also the suppression of the cost of capital, taking interest rates down low, was all a function of this challenge of trying to create growth in what was a very indebted world, and still is, and a world that was changing significantly with things like digitalization.

Brett Lewthwaite:

And so if we look at all those things now, and we look at them post the pandemic, almost all of them are now worse, far worse and getting worse almost every day. So indebtedness is worse, dependencies on very low rates and quantitative easing is still all out there, perhaps even more so, given that we've had another two years of super liquidity injections. The demographic situation hasn't really evolved too much. And obviously here we are not even in the same room, recording a podcast, and we all know the benefits of digitalization and what's sweeping through on that front. And so in many ways, when you look at the forces that were creating lower for longer, they haven't changed. And as I like to remind people, they're being things, they do weigh on the environment and no, some magical fairy hasn't come along and cured them. And so they're still with us, and I believe at some point in time, they'll continue to exert their influence.

Brett Lewthwaite:

But the second part of this is that what's now occurring is shocks are always unexpected, but there's this supply shock that is now rolling through, that is really challenging that environment. When you think about the prior question and how we said, well, why are we having a supply shock? It is a lack of needs that is now apparent, predominantly due to the war in Ukraine. So an energy shortage, an input shortage of important metals, perhaps more concerningly, a lack of food. So we're seeing a number of countries ban exports of things that they believe might be better left, kept at home. And so it's how these two worlds are colliding that I think will really help us understand the outlook for inflation, but also interest rates. And I think it's early in that phase, I think it's challenging in the sense that in the past, central banks were always dealing with shocks to demand or slumps in demand. And so they could react to that by either cutting interest rates towards zero, or they could provide more and more liquidity.

Brett Lewthwaite:

In this instance, it is a lack of supply of needs that is the problem or a supply shock. And just doing more monetary policy or just doing more quantitative easing, doesn't help here. It makes it worse. And so to some degree, central banks have to go the other way, but even if they do, it's not like central banks can create oil or base metals or precious metals, or create wheat and things for food. And so how that supply shock inflation pulse interacts with that lower for longer structurally challenged world, is the place that you and I currently find ourselves, and it's very interesting to watch it play out.

Paul O’Connor:

It really is, it's fascinating. But I think you've well articulated those long term thematics, or I guess, headwinds that fixed income markets have been facing there. And it is interesting whether the whole supply shock issue is just a short-term transitory view there. But why is a supply shock different, Brett?

Brett Lewthwaite:

I guess to some degree, the example with the war with Russia and Ukraine is a great example. It is a shortage of needs leading to price increases, and those price increases then become input costs that are generally passed on. So the high cost of living becomes a challenge. In the past, it was a lack of demand, a risk of higher unemployment, these sorts of things that central banks were most concerned with. And they were able to do more and more and more to try and create the sense of normality of stability. And as we know, through that process, things like financial markets benefited considerably. Whereas in this instance, to some degree, central banks have to lean against demand here to perhaps try and right size it, so that demand for in this instance, many needs falls, trying to alleviate that inflation pressure.

Brett Lewthwaite:

And as we said, it's not like they can walk into the Russia Ukraine situation and restore the conflict or resolve the conflict. The energy dependence in Europe and how Russia supplies much of the energy to places like Germany, it doesn't necessarily lend itself to a quick resolution or one that central banks can involve themselves in. And so how a supply shock can resolve itself is very different to some of the things that policy makers were able to do in the past. And so to some degree, we have significant situation that we've worked through being that lower for longer environment, where we used to say that central banks were able to try and contain risks or suppress volatility. Whereas in this environment, they almost have to do the opposite. They have to let interest rates rise. They can't provide liquidity to the system. They have to tighten financial conditions significantly. And as they do that, risk assets underperform, demand starts to be challenged, and they hope through that mechanism, that inflation is somewhat corrected.

Brett Lewthwaite:

I think to some degree, one way to think about this is that when you have inflation in a society, you're essentially putting a higher cost of living across the entire society. And as that takes place, people become very unhappy with that. You start to see that more noticeably in emerging market countries where you might see things like riots, but even in the west, you're more likely to see unhappiness expressed at the polls and you see political turnover and the like. But ultimately, people become pretty unhappy if they are indeed living in inflation environment and their wages can't keep up. And so that ultimately is a challenge to, I guess stability, that central banks are charged with trying to address.

Brett Lewthwaite:

And so it is their job to try and get on top of that. But the only tools they have really are demand tools. And to do that through higher interest rates and less quantitative easing, or even quantitative tightening, essentially hits financial markets. And as you hit financial markets and do that in real time, you're never really going to know whether you've done enough on that side, that ultimately the inflation pressure might go away. So I guess the nature of how you try and create stability or try and create a smoother business cycle for longer term prosperity is far more challenged from a policy maker point of view, when you're experiencing a supply shock than when perhaps you're dealing with a demand one.

Paul O’Connor:

Yeah, certainly interesting, your comments there, Brett, around the, I guess, monetary policy, and to a degree fiscal policy, can address demand issues, but the supply issues are different. You need a completely different, and I guess, longer term strategy to try and address. But just as an aside, I found it interesting, an example of how a supply shock can occur, in my mind was the other night I was just watching a documentary on the Volkswagen car plant. I was staggered that it was 60 kilometres of roads and 50 kilometres of train line. It was like a huge suburb in Germany. But the amount of stock that each factory had, was not months, was not weeks, was days. And the supply was coming from four points of the planet. So any slight issue in terms of supply to that factory, they're going to slow down and have to stop building cars.

Paul O’Connor:

That really is a relevant example of how a supply shock can occur, in my mind anyway. So yeah, I found that interesting as they're trying to run these companies in a more streamlined manner and not have a lot of inventory sitting on the shelves and logistic warehouses, and what have you, it made the risks of the supply shock greater the way those companies have been trying to be run efficiently.

Paul O’Connor:

Now, with Australian GDP growth expected to be around 3.7% this year, most people would think the economy's performing well and recovering well. But I guess this is a little counter to what your comments have been. So, what are your thoughts there on the outlook there for Aussie GDP and where it can move?

Brett Lewthwaite:

Yeah, it's interesting. I think the Australian economy has been performing quite well, and I think many of the global economies haven't been performing too badly at all, actually. And to some degree that's part of coming out of, or recovering from the COVID lockdowns and the likes. So I think that recovery is still there, and I think it creates the appearance that things are going quite a lot better than perhaps they are. But I think it's also interesting, like what I've noticed in a lot of commentary around current environment, is that people are debating the inflation situation. Is it transitory? Is it structural? I told you so, this monetary policy thing would end up in this situation. There's all this kind of discussion. And then there's this sense that, is demand going well? And this fascination with understanding the impact on the economy.

Brett Lewthwaite:

And I sort of scratch my head a little bit at that point, because when I think about the economy, ever since the financial crisis, the macro cycle really hasn't mattered that much. I think it was somewhat convenient not to be too concerned because everyone learnt that when central banks were there doing quantitative easing, everyone knows that everyone knows that, ultimately when they're there, as the prices go up, and the amount of times where they tried to walk away, but had to stop and then turn around and go back to it, almost became a dependency in the system. And I guess what I'm trying to highlight here is that the economy hasn't really mattered to financial markets for a long time. And to now be focusing on that and saying, look, I think demand's holding up. And a lot of the demand indicators that are holding up are either ones coming out of the COVID lockdowns and things, or they're a bit backward looking, they kind of missed the point.

Brett Lewthwaite:

It's like the thing that really thrived in the last 12 to 15 years were financial markets and financialization, all that liquidity, trillions and trillions of dollars, all that next to zero cost of borrowing, what has occurred there. And the world that we're talking about now is one with a supply shock and perhaps more persistent inflation that has the supply of needs, like energy and food, are difficult to restore, that we have an inflation environment that central banks need to respond to. And to do that, they have to take the cost of capital up. They can't provide that liquidity anymore. And it's those dependencies that have been built into financial markets that will matter more from here. So the more that central banks hike, the more that they quantitatively tighten, then all those wonderful behaviours that led to the high asset prices and those beautiful, upward markets, and even some of the crazy things out there in terms of asset valuations, the more they correct.

Brett Lewthwaite:

And it's true, that sense where the financial markets are more likely to start to impact on the economy, not the other way around. And so what I would say is there's a timing issue to this, but I would be focused more on financial market conditions. What's happening to risk asset prices, what that might then be doing to decision making within companies in terms of addressing to what looks like a softer environment or a stagflationary environment, which is one where growth is more challenged and you are experiencing inflation, as the right way to be thinking about how financial markets might perform looking forward.

Paul O’Connor:

I must admit there Brett, many times in recent years, I've started to think that will we ever see a deep recession again, or will just central banks continue to step in? And it's interesting, the comments that financial markets have just started to ignore the economic cycle. And I do wonder when one day it will have to play out and they will have to revert back to actual financial markets. But I think it'll depend on central banks and how they move forward, and if they continue extraordinary monetary policy, every time an economy slows. So how do you see all of this playing out? I mean, will central banks hike rates like markets have priced in, and if so, what will be the likely impacts?

Brett Lewthwaite:

It's interesting. And I think you make a really good point there, is that financial markets have already priced in quite a lot of aggressive tightening, most notably here in Australia. I mean, Australia doesn't have the inflation challenges that places like the United States has, or not yet anyway. There's at least a lag there. And obviously we know that our system is very different. Many mortgages in Australia are floating rate. We know that the RBA in the last cycle, 12 years ago, didn't even get to hike. So, in terms of perhaps seeing cash rates up north of two and a half or 3%, things that we haven't seen for a very long time, feels quite aggressive. And even the Federal Reserve getting to where they might have to, seems like a pretty big step forward. And I guess why that's occurring is because those inflation numbers that are coming through, as a function of COVID, as a function of supply shortages to do with the war, and now China lockdowns, and that persistency of it all, does on paper, require a pretty significant reaction from central banks.

Brett Lewthwaite:

Like if inflation's running at five or 8%, then what are cash rates doing down at one. So financial markets have said, well, look, we can see where this will be the case. They're probably looking at the economy saying, gee, the economy's withstanding this quite well, but I think there's that other element that I touched on there, is that the thing that's most likely to be impacted is financial markets. And it will be then how financial markets affect the economy that we have to watch. And so when I look at it, at the moment I ask myself, that if indeed central banks are able to get interest rate hikes up to two and a half or 3%, then I do think financial markets, which have become quite used to zero rates and used to quantitative easing, not quantitative tightening, will have a fairly challenged time.

Brett Lewthwaite:

And so the question, I think we're all asking ourselves, is how much damage to demand or correction in financial markets might that occur, will central banks have to do more to perhaps get on top of inflation? And how do you sequence that with stickier inflation, that's unlikely to improve, growth that's a bit of a lagging indicator, and financial markets that are more likely to price this real term? And so my sense is that the dependencies, the leverage that's built up in the system, are much, much more significant than most people think. And that central banks won't have to do too much before they create a certain amount of unwinding of that leverage in financial markets. And as such, some of the things that are priced in, are probably too much to the aggressive side. I think there's also this other side where many participants are used to having what they call, the central bank put in there. At a certain point, central banks come back and help, and people are looking to buy the dip.

Brett Lewthwaite:

I think this time around, we have to be cautious around how quickly that might occur if indeed they turn around too quickly and they think, oh, hang on a sec. We've created a problem in financial markets and that's going to hurt the economy. And ultimately we've gone from having a supply shock to a problem with growth. They might turn around and find the inflation problem that we're dealing with hasn't actually gone away. And so what I think that means is that whilst I don't think central banks can probably do as much as the market is currently forecasting, I do think that they have to head in that direction and they probably have to be more tolerant of financial market volatility than people think. And the inflation situation probably isn't going to give them cover to turn around and help out again anytime soon. And so in amongst all that, quite a bit more volatility is most likely heading our way, from what we can see.

Paul O’Connor:

So what are the consequences of quantitative tightening? And any idea what a normal cash rate in Australia could look like over the next 12 to 18 months?

Brett Lewthwaite:

Yeah. I mean, as I mentioned earlier, the thing that nobody really talks about is that financial markets haven't enjoyed the withdrawal of quantitative easing at any point in time, over the last 12 to 14 years. They haven't had to. If the Fed was backing away, the ECB and Japan were adding, or collectively they've all been adding. So the notion of always having additional liquidity in the system has been there, but quietly so. But now we have almost all central banks, excluding Japan, going the other way. And they realise that if indeed we have inflation problems, that they shouldn't be adding more liquidity. And so they're very keen to go to quantitative tightening. But in and of itself, we know that financial markets have struggled at any other time where QE has been taken away. To some degree, it's almost like the training wheels have been on and every time central banks try to take them off in terms of take the quantitative easing away, markets wobble, they fall and they require that support again.

Brett Lewthwaite:

And so at the moment with the inflation pulse as it is, we're going to have to go without those training wheels. And so that's in and of itself quite significant. But on top of that, you're also going to have interest rate hikes, probably not as much as what's in markets at the moment, but perhaps we're going to see that as well. You have a lot of the fiscal policies that were beneficial in the past couple of years rolling off now. So you've got a bit of fiscal drag coming through. You have wider credit spreads, lower equity prices, numerous headwinds here that are really going to put significant headwinds in front of demand or growth. And so if you add all that together and understand how they all affect each other, the path to a cash rate of two and a half or 3% in Australia, looks like pretty hard work.

Brett Lewthwaite:

Perhaps the Fed will need to go a bit further because the inflation pulse is a bit higher there. But ultimately beyond that, I would imagine that there'd be fairly substantial impacts in the economy, particularly given what's occurred in housing markets in Australia over the last three to five years, where a lot of that very low cost of cash rates for example, has led to very, very high housing prices. And as we know, most Australians have floating rate mortgages. So a two to 3% tightening there you think would have a material impact on the local economy.

Brett Lewthwaite:

I think about all those headwinds. I think about the challenge that inflation is creating, the challenges on cost of living as well. And whilst on paper, it seems like a good idea, I think it'd be challenging for central banks to take cash rates too high without material impacts to the economy, which I don't think any of them really want to be creating.

Paul O’Connor:

So I guess, trying to distil your comments and your macro views there, to your day job effectively, what does this all mean for bond markets and fixed income portfolio positioning? And with US and Aussie 10 year bond yields well above 3%, am I guessing the temptation to take on some duration or interest rate risk in your portfolios is increasing?

Brett Lewthwaite:

Yeah, look, I think that's a fair statement. A lot of the discussions we're talking about at the moment is that in a pretty short period of time, bond yields have increased substantially. Being someone who spoke a lot about lower for longer, there's always been episodes in the past where bond yields have drifted higher for a period, but this time they've gone a lot further than I would've thought was possible, given all the different constraints out there, keeping in mind though that in the past we didn't have a supply shock. And so the supply shock is creating quite a lot of cross currents that are very challenging for policy makers. That rise has meant, as you've seen, some of the biggest draw downs in fixed income total returns in the last four months than we've ever seen.

Brett Lewthwaite:

Now that can sometimes be quite concerning because you think, wow, if those returns can happen in four months, what happens if they get worse, and quite possibly, they could worsen a little bit further. But generally when you see pullbacks as significant as that, the discussion really does turn to things about low buying opportunities. And for the first time in a long time, looking at fairly attractive bond yields having that counter balance in portfolios. The only caution we'd have with that is that there's still quite a lot of noise on that inflation front. It doesn't look like the sticky inflation challenges, around energy and food, particularly relating to the war, about to be resolved. That looks more prolonged. China's still dealing with COVID. That could create more supply bottlenecks. And so that situation where inflation appears high and sticky, it's very much part of the narrative.

Brett Lewthwaite:

A lot of people question where bond yields should be as opposed to where they are, could mean that the situation remains volatile. And what I mean by that is they could drift higher again from here or they could spend periods of time where they rally quite hard. And I think it's really about at certain points, around these levels to higher, gradually accumulating duration, and being aware that whilst they'll be volatile, there'll be good months and some bad months, we're actually looking at some of the most attractive yields, attractive returns from a fixed income point of view that we've seen for many years.

Brett Lewthwaite:

And when I revert back to my conversation about that lower for longer component, I talked about those structural challenges, how they've gotten worse and how the magic debt fairies haven't gone and resolved them. We do anticipate at some point in time they'll re-exert themselves. And so from a longer term perspective, having more duration in portfolios as counter balance, particularly given risk assets are probably going to be fairly volatile from here, seems to make a lot of sense.

Paul O’Connor:

So maybe to finish with, Brett, how about credit? Can you provide a few comments about spreads and what areas of credit offer the opportunities and what areas you're avoiding at the moment?

Brett Lewthwaite:

Yeah, credit, it's been quite interesting. We've talked about bond yields increasing quite a lot in the first part of this year. I think it's also worth noting that credit spreads have experienced quite a bit of widening as well. More so in the investment grade universe, they're at levels which you would normally associate with downturns, not necessarily financial crisis or deep recessions, but they're definitely pricing in a bit of concern about the outlook. And so their valuations have definitely improved. But having said that, they are somewhat linked to other risk assets and some parts, particularly the longer dated components of risk assets, things like NASDAQ, some of the tech stocks, which have experienced some pretty significant draw downs over the first few weeks, that volatility could remain. And so, there is the chance that credit conditions continue to tighten and spreads tighten further.

Brett Lewthwaite:

And we'd say that in particular places, like high yield, which can really widen quite a lot more in things like recessions and downturns, probably areas that you still want to be somewhat cautious. But as we've talked about on many occasion before, I mean, fixed income markets are generally the heart of financial markets and when they move, we definitely pay attention. To some degree, the bond market is the heart, but the most important part is the credit market. And if credit markets aren't functioning, if they freeze or they lock up essentially, blood isn't flowing to the system and through that, you get the cardiac arrest. And our sense is that there's a limit to where credit markets function normally. And those credit spread levels are probably quite a bit lower than where they were in the past.

Brett Lewthwaite:

And so it may be as low as high yield only widening out to 500 basis points over treasury's is where all of a sudden those markets go into distress. Now, if credit doesn't flow, growth is very, very challenged. And if credit's not flowing, you risk things like financial crisis and massive de-leveraging. And so it would be very interesting to see the central bank function at that point of time. And so to some degree on credit, we're becoming more constructive, but we think that given the inflation pulse that's in the system, given some of the volatility we can see coming down the pipe, perhaps we're looking for signs of credit to start to get a bit more distressed and realising that policy makers won't necessarily enjoy that and probably start to lessen their rhetoric about the outlook there. And it might be that time where we start to accumulate a little bit more.

Brett Lewthwaite:

So, for the time being, warming to it, but think there's potentially a little bit more downside. But from there you've got higher bond yields, wider credit spreads, and perhaps some very encouraging returns from a fixed income perspective, which we quite enjoy, given the very low yield environment we've been in for some time.

Paul O’Connor:

On that note, we'll bring the podcast to a conclusion. Thank you very much, Brett, for participating in the podcast today. I've found your insights really fascinating. I mean, your comments on inflation, probably being more supply driven than demand driven, I guess the inadequacy of central bank policies where monetary policy typically has a bigger impact on demand issues than supply issues, really been fascinating. And it's caused me to think a lot deeper there about fixed interest positioning. And then finally your comments there around the more attractive yields currently available in fixed income markets. So there is a positive lining, even though we do have a lot of challenges to get over there that I think are well summarised by your five Ds that you mentioned earlier, around debt, dependencies, demographics, digitalization and de-globalisation. So, thank you, Brett. It's been an enjoyable discussion with you and we really do appreciate your time and you joining us on the podcast today.

Brett Lewthwaite:

Thank you, Paul. Appreciate it. Enjoyed myself a lot. Thank you.

Paul O’Connor:

Excellent. And to the listeners, thank you very much for joining us today and I'll look forward to you joining us on the next instalment of the Netwealth Portfolio Construction podcast series.

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