Pushing out the recession call

The US consumer is proving to be resilient in the face of the aggressive rate hiking cycle by the US Federal Reserve (the Fed). One explanation is that the aggressive rate hike cycle has helped improve real wages in 2023. At the start of the current inflationary period, real wages dipped as inflation picked up and wages remained stagnant, but this was offset by still-elevated savings levels, thanks to prior COVID stimulus payments. 

Consumers are now benefitting because their wages are falling slower than headline inflation, leading to a real wage boost which is likely fuelling consumption. Wages will inevitably fall in line with inflation, but for now, the capacity to consume has been extended, pushing out the cycle and the potential start of a recession.

Labour hoarding and lending standards yet to make their mark

Part of the conundrum comes from the tightness of the labour market. Companies appear to be hoarding labour. Given how hard it was to find workers post COVID, companies are not willing to let go of them so easily, even if it impacts margins in the short term. There are signs of the labour market cracking, with the number of job openings and average hourly earnings declining slowly but surely. 

Manufacturing employment is contracting, temporary workers have been shed, and the number of states with initial claims over 20% year on year are at levels consistent with the start of a recession. However, until companies are willing to lay off staff to protect margins, the consumer remains buoyant.

We are around 18 months into a rate hiking cycle, which is typically when a recession would rear its ugly head, but given how low rates were at the start and how much better household and corporate balance sheets are post-2008, it may take slightly longer this time to play out. 

The tightening in lending standards is also yet to bite, however, it is clear that funding is becoming more expensive and less available. We believe this will eventually lead to a slowdown, despite uncertainty around the timing. Our recession probability model remains high, however given the real wage growth extension, we have pushed back our recession call to the end of 2023 or the first quarter of 2024.

Portfolio positioning tuned to enhance yield

In terms of portfolio positioning, we have continued to position the portfolio to enhance the yield opportunities, primarily by adding high-quality carry. As yields on sovereign issuers have risen, the yield on investment-grade corporate credit has moved above 5%, which presents an attractive risk/reward trade-off. Cash holdings at month end were 14% from a peak of 50% earlier in the year as we have deployed capital. This has been primarily to Australian investment grade credit, given valuations are currently pricing in recession-type risk premia. The high-quality nature of the market means any potential loss from default likely remains negligible. We have also added to Australian bank hybrids, given they are offering an elevated yield for subordination risk.

We have also closed down the net short global high-yield position. With recession seemingly pushed out, the anticipated repricing of high yield has not yet materialised. While we see this market as the most expensive in the credit universe, we have neutralised our short to remove the negative carry of holding this position. As we become more confident on the timing of the recession we expect to tactically reinstate the short position.

On the duration side, we have retained a short Japanese bond position. The BoJ has adjusted its yield curve control settings to allow for somewhat higher bond yields, which has seen the yield on 10-year Japanese Government Bonds begin to rise. This benefited performance.

We are also adjusting the cross-market and yield curve positioning. We have been reducing our US duration exposure in favour of Australia as we believe the RBA is closer to the peak in rates and the impact of recent rate rises will be accentuated through the mortgage market. We have also shifted exposure to shorter-maturity bonds, where yields in Australia are priced for further tightening by the RBA.

On the currency side, we have retained our long USD and long JPY at 2% each as a downside risk hedge. Cash is now at 14% which maintains portfolio liquidity but importantly we have taken advantage of high-quality carry to boost portfolio yield. With a yield to maturity of 5.5% at month end we see the Schroder Absolute Return Income Fund as continuing to provide income via our defensive, diversified and active approach.

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Schroder Absolute Return Income (Managed Fund) (PAYS)

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