Looking under the hood

It seems like a blink of an eye; March is underway, and Christmas is starting to feel like a distant memory. Just like we have all moved on from Christmas and settled into new routines, markets are also moving on from the Covid ravaged days of 2020 to a “new normal”, whatever that may be.

As markets transition to a new normal, we are going to see bouts of meaningful volatility and investors will have to factor ongoing volatility into expectations for the foreseeable future. February saw the first signs of market volatility as long-dated bond rates rose suddenly to their highest levels in a year.

Investors are scratching their heads to make sense of the rally in bond yields.

In a highly debt-burdened world a slight increase in the yields can turn out to be very sensitive for the global economy. Over the last week, bond yields rose on the hopes of pent-up demand, improved growth, and inflation expectations. Fundamentally, equity markets should like the news of strong growth, but it seems like markets love low interest rates more than anything else.

• Simply put, bonds had been priced for misery. Shares and company credit on the other hand have been priced for blue skies as economies and company profits recover from the Covid crisis.

• Central Banks (particularly the Federal Reserve in the US and the Reserve Bank here in Australia), flagged that they would let inflation run above target for a period of time. For a bond investor, this is a nightmare scenario as they are invested in bonds that currently pay deeply negative yields, when adjusted for inflation.

• Lastly, there is still massive fiscal stimulus occurring with a prime example being the US$1.9 trillion package just passed by the Biden Administration. These measures refuel the US consumer, keep positive earnings momentum intact for corporate America and lead to higher inflation expectations.

We don’t believe higher long-term bond yields will cause material downside risk for share markets in the near term. For this to happen we would need to see actual inflation break above pre-Covid levels, and for Central Banks to back away from their guidance of multi-year periods of ultra-low interest rates. Interest rates are usually increased to combat the sustained rise in inflation. We don’t see either scenario likely in the short-term because economies still have a huge amount of spare capacity, gaps in full employment, and subdued wages growth, the likes of which we haven’t seen for decades.

Looking under the hood, yields rise along with inflation expectations when investors expect a stronger and more sustained recovery.

This leaves us in a a Covid contained environment combined with gigantic fiscal stimulus and robust corporate earnings leading up to improved expectations for economic and inflation growth. These advances tend to increase the long-dated bond yields, followed by risk aversion and equity markets getting shaky. Central Banks are not expected to back away from low interest rate policy until they see a permanent rise in inflation, and in our view, this will stabilise the equity markets.

Rethinking the role of bonds 

Since the advent of modern portfolio theory, the 60/40 allocation between equities and bonds have helped investors to achieve benchmark like returns with 40% lower volatility. As the interest rates globally are flirting with Zero, the value proposition of 60/40 portfolio is challenged. While bonds offer negative real yields after inflation and the benefits of diversification are also limited, there’s a need to reshape the role of bonds in a balanced portfolio.

The rising yields have brought back the steepness in the yield curve which is a powerful tool for investors to generate return, as the bonds roll down the yield curve, offers capital appreciation in addition to the coupon payments. A single bond strategy/fund can no no longer provide the suite of solution investors require from their fixed income bucket, i.e. to preserve capital, seek income and offset equity risk. In our view, the best way to approach this problem is to combine traditional fixed income strategies with active defensive alternative strategies in order to generate true alpha.

Bottom Line:

 There is no denying that 2021 requires a rethink of traditional portfolio management approaches while building income strategies, preserving capital, or adding layers of diversification in investment portfolios. Markets continue their run to climb through the wall of worries. When an accommodative monetary policy joins forces with a gigantic fiscal stimulus, above expectation corporate earnings and an effective rollout of vaccines, it paves the way for a big return to normal later this year. It has been proven time and again, for an investor, the biggest investment risk is not taking any risk. Investors who sat on the sidelines are proof.