Macquarie True Index Aust Fixed Interest (MAQ0211AU) Report & Performance

Fixed income markets are acutely focused on the outlook for inflation and the reaction by central banks. These two themes were central to our debates within the Macquarie Fixed Income team’s recent global Strategic Forum. From a macroeconomic perspective, a deep dive into the drivers of aggregate demand and aggregate supply has enabled us to understand that the currently high inflation has been largely a product of a slow recovery in supply and demand being broadly back to the pre-pandemic trend. Looking into 2022, we asked what are the big demand drivers and noted that policies – both monetary and fiscal – were moving in the opposite direction from those of the past two years. Gradually, we expect this action to drag demand lower. We note the narrative that the consumers can drive demand higher, fuelled by higher wages and excess savings, but see that there is little actual evidence in the spending data that supports an above-trend consumption. Finally, on the supply side, we note that the pandemic needs to pass for a sustainable improvement to take place, and recent evidence gives optimism for progress through this year.

Thus, we expect inflation to trend lower in 2022, notably in the second quarter and more noticeably later in the year. This should offer respite the investor and central bank fear that inflation is a structural problem, but this path is not without risks from the virus, factors such as oil as well as policy (error). This implies a tricky investment outlook path to navigate, where periods of volatility spikes should be expected. We also recognise the investors’ need for yield. During 2021, our investment approach was cautious, holding low levels of duration and low levels of exposure to risk assets. This gives our team the opportunity to take advantage of expected volatility in 2022 to add duration and risk either from both our top-down and bottom-up processes

The Fund outperformed the benchmark during the month, driven by security selection as well as duration and curve positioning. Within security selection, the Fund has been overweight to the ultra-long Australian Commonwealth Government Bonds (ACGBs) given the steepness relative to global curves, but has reduced this position slightly in size given it has performed well in recent months, with micro steepening trades expressed from the 20 year area towards 15 year bonds. The tapering of quantitative easing (QE) should drive the outperformance of ultra-long bonds given the Reserve Bank of Australia (RBA) has only purchased sub-12 year tenors, and we will see the relative scarcity of those shorter tenors reverse as QE ends.

Further micro steepening trades were expressed in the 10 year bonds where we bought the 2030 maturity ACGB given its cheapness on leaving the futures basket against longer tenor bonds. In semi-government bonds, we rotated out of mid curve Western Australia bonds that were trading relatively expensive in favour of Queensland, which we view as relatively cheap. We are slightly overweight swap spread exposure given the value on offer against ACGBs and semis. We expect that derivatives should outperform physical securities as the RBA continues to taper their asset purchasing program. Consistent with this, we sold our holdings of the 3 year bonds into futures given the arbitrage opportunity on offer. The Fund’s credit security selection contributed positively to performance over the month. With the dramatic rally in Tier 2 spreads in December, financial and corporate subordinated debt were a key contributor to the outperformance. The Fund remains defensively positioned with credit default swap (CDS) offsets, and during the month added some protective investment grade CDX positions to further hedge credit risk. Over the month, the Fund participated in a primary transaction from Centuria Industrial REIT.

The market repricing of short-term rate expectations and the change in tone by several central banks have unsettled the rate markets but, to date, these are being largely ignored by risk markets. Our sense is that the reaction across markets are not consistent, but the key test may not come until 2022 on whether central banks follow the markets lead and actually deliver tighter monetary policy. Meanwhile, the macro fundamentals continue to fuel the debate over whether current inflation will prove transitory or structural. Commodity prices, particularly oil and gas, are re-fuelling the upside risk for inflation. Labour shortages and wage pressures are keeping central banks restless. However, growth during the third quarter was soft and in many cases the start of the fourth quarter remains soft. This mix of data has the stagflation debate raging across media, economists and market participants.

The core of the debate is around whether current inflation is being driven by supply chain problems or rising demand. In addition, the word ‘transitory’ was used to describe the inflation surge in 2021 without any clear definition of what transitory means. We sit firmly in the camp that the world continues to be driven by a unique event as a result of the pandemic and while this persists, so will the supply chain problems. Demand surge is largely the result of a redistribution of spending from services to goods, which was supported by unprecedented government transfers/support to displaced workers. The world is working together to move on from the pandemic and when this happens the supply chain problems too should be released, the problem is that we do not know when that will happen.