Background
FIIG’s Head of Research, Philip Brown, recently released the Quarterly Macro Outlook, providing insight into what to expect from markets going into year-end. In last edition of The Wire, we covered Part 1, which examined the current economic landscape and the outlook for the Reserve Bank of Australia (RBA). In Part 2 of this report, we bring you a condensed version of the full report, where we explore the key risks that might undermine the economy along with mitigants. We preface this article by stating that we don’t believe any of the risks are likely, but it is worth discussing how best to position a fixed income portfolio to protect capital. Please click here to read the FIIG Quarterly Macro Outlook in full.
Risk 1. Slow breakdown of US political and social institutions
In the year since President Trump won the 2024 election, the US’s place in the world has been radically altered.
This recent period of fragmentation of previously assumed democratic norms may self-correct thanks to the strength of US institutions, but we shouldn’t assume that it will. US institutions have survived for centuries and are very strong – but they are also under pressure at present and there is no guarantee they will continue unchanged.
So far, this weakening of institutions has not impacted the US economy directly, but the US financial markets are starting to be affected. For example, TikTok was sold for a price much lower than previously assumed. There is also material economic risk from changes to US immigration policy. The US ICE is now deporting large numbers of people with seemingly few restraints. Immigration restrictions will likely result in both low skilled and high skilled labour shortages, undermining productivity and innovation.
The risk implicit in the degradation of US institutions is a risk of undercutting the economic dynamism and growth of the US economy. This risk would not necessarily cause immediate impacts on financial asset prices, but the longer-term risk is substantial. A medium-term economic malaise driven by brain drain and a lack of economic entrepreneurship would see growing problems with US productivity. The Federal Open Markets Committee (FOMC) would likely cut rates over time as the malaise continued. However, the US would find it difficult to create economic growth against such a backdrop. We would expect to see short-term rates in the US drop slowly over time, while the longer-end would notice the risks inherent in a country with a weakening political structure and may well sell off.
The best solution for investors who fear this risk is to limit exposure to USD assets and to maintain a moderate duration exposure, since an economic malaise in the US probably causes economic slowdowns in most other countries.
For FIIG investors who are concerned about a degradation of US institutions, this means supplementing our general advice of long-duration and 7Y focus with an extra overlay:
- Selling USD assets and repatriating to Australia.
- Maintaining solid credit exposure to non-US names.
- Australian banks, both major and smaller, are good options, but beware of concentration
- Infrastructure bonds, like ports and airports, offer good diversification.
- Risk 2. A Sovereign debt crisis in advanced European countries like the UK and France
Risk 2. A Sovereign debt crisis in advanced European countries like the UK and France
Unlike the slow-burning crisis that we outlined in US institutions, a European Government debt crisis would likely be explosive if it occurred. As we saw in the 2010-2012 period with the European peripheral debt crisis, these events can become exceptionally fast-moving once they get started. The fundamental issue here is compound interest. Once governments start to face rising interest costs, the interest compounds. The higher interest costs raise the deficit, which increases the borrowing in the short-term, which raises the interest costs and so on.
The European countries most under pressure are the UK and France, with the US also deserving an (dis)honourable mention. The spreads on European sovereign debts are already reasonably wide. The difference between the 30Y government bond yield and the 30Y OIS (Overnight Index Swap) is something to watch, as it functions as a canary in the coal mine. The OIS is a measure of the anticipated cash rate, so the difference between the government bond and the anticipated cash rate can be read as a measure of credit risk in the government bonds.
We would not be particularly concerned about European banks, since many of the large European banks are, in fact, larger than the sovereigns now by many measures. The European banks, even the French ones, are relatively well diversified across the continent, too. There is some argument to be made to sell BPCE, which does have a strong exposure to France itself, but the other names like BNP Paribas and Barclays are well divorced from their respective sovereigns. The risks here are actually tilted towards a “standard” recession as the most likely outcome.
For FIIG investors who are concerned about the risk of over-indebtedness in European sovereigns, this means:
- Considering exposure to sovereign-affiliated names like EDF.
- Ensure European bank holdings are diversified.
- Move towards Australian and US names within the portfolio.
- Lengthen duration in the low-risk names. We like German utility names, like ENBW and E.ON.
Risk 3. A material re-awakening of inflation in Australia.
This is a risk that would see FIIG’s broadest advice – to be long duration and long in the 5Y-7Y sector – perform reasonably poorly, so it’s a risk case we pay attention to. The most likely sources of a rebound in Australian inflation would be from strength in the Australian consumer sector, which seems doubtful if our understanding of the labour market is correct. However, that’s not the only way it could play out. Our general understanding also includes an assumption that the State Government infrastructure spending is now winding down and that migration into Australia is slowing. If any of these assumptions prove incorrect, you could also see increased demand and, from there, increased inflation. The other two potential sources of inflation are different in that they are non-economic, or at least, not driven by the economy initially. These are changes to food prices because of climate change or an increase in military spending because of geopolitics. If there is an outbreak of inflation driven by the consumer, the RBA will, at first, simply pause the rate-cutting cycle. However, there is a chance they will move back to raising rates. That would cause a sell-off in the 3Y-7Y fixed rate bonds.
If there is an external event driving inflation, the RBA is probably less likely to move rates in the short term than for a consumption-driven increase in demand. Raising the cash rate doesn’t change the price of food in any way, nor does it end a drought nor put out a bushfire.
If you are concerned about this type of risk scenario, it might be time to start rotating your portfolio into the floating rate notes (FRNs) we have on offer. The relatively new RAM income notes are floating rate and have a high yield. They would perform well in the domestic-driven inflation scenarios since they offer floating coupons and are exposed mainly to the property market. If the Australian consumer is strong enough to drive up prices through demand, then it speaks to an overall strength in the housing market, too. Other floating rate bonds that might perform well are the AMP Oct-30 call and the Judo Oct-30 call. The Clearview Mar-30 call FRN is another option that is a floating rate and has a relatively high yield.
A burst of inflation driven by climate change or military spending is harder to prepare for since it might entail stronger inflation and weaker growth at the same time. To be fully protected from inflation, you need something with an explicit link to inflation, like an Index Annuity Bond (IAB) or a CPI-Linked Bond. The Sydney Airport Nov-30 ILB is tailor-made for this protection and still offers a solid yield of 3.23% plus inflation.
For FIIG investors who perceive there is a risk of a material rise in inflation, this means:
- Consider selling fixed rate bonds in favour of FRNs
- RAM income notes, AMP and Clearview are good options.
- Directly take exposusre to inflation via IAB or CIBs, like Sydney Airport
We wish to reiterate that the risk cases outlined here are exactly that: risks to our core understanding. Our core recommendation of expecting a slow elongated rate cutting cycle continues to hold, and with it our key recommendation to own 5Y-7Y fixed rate paper, with good credit diversification. This choice of the 5Y to 7Y sector is because the 5Y to 7Y sector is the steepest part of the credit curve and provides a good opportunity to own bonds that benefit from roll-down.