23 January 2017
The steep rise of bond yields in recent weeks and months hasn’t really been a surprise – but nor did anyone really know when the sell-off would begin. Investors had recognised the remarkable over-valuation of the asset class for a long time, but the greater fool theory dictated they had an incentive to stay invested while prices kept rising, with yields compressing.
Bond yields have been incredibly low, and unsustainably so, for some time, with over $13.4tn in debt estimated to be on a negative yield in August of this year (source: FT/Tradeweb). The problem is that only a brave investor would shun such an overvalued asset if they believe enough buyers remain in the market that the price can rise even further.
We must be careful making predictions about the bond bubble bursting as we have seen yields back up before, only to subsequently resume their multi-year bull trend. But yields are so low that the asset class on a standalone basis looks one of the most expensive ever, so it seems likely we may have reached an inflexion point.
A range of factors have contributed to the sell-off. Inflation expectations have been edging up to reflect the lagged impact of the early 2016 recovery in energy prices. For UK investors, this has been accentuated post-Brexit vote by the likelihood of imported inflation due to sterling’s fall. We have also seen growing acceptance that QE and similar monetary measures may be losing their effectiveness in dictating investor behaviour, and therefore may be coming to an end (meaning less demand for bonds).
Recently, the rise in inflation expectations and yields has gathered pace. We would attribute a large part of this spike to two related factors: populism and a switch to fiscal stimulus.
Populism has gathered momentum, with perceived anti-establishment votes in the UK, US and Italy over the course of 2016. The driving forces behind this political trend are the same that may see a rejection of globalisation and a rise in domestic fiscal investment – via infrastructure projects for example. Few would argue that globalisation does not serve to increase productivity within the global economy, but the man-on-the-street in the developed world is becoming increasingly aware that the benefits may not be accruing to them, but rather to developing nations, who are closing the inequality gap, and to international businesses (and their shareholders).
In recent years, synchronisation between asset classes internationally has been rising, a result of global efforts to stage a recovery from the 2008 global financial crisis. One of the main effects of quantitative easing has been to drive valuations up across the board, defying the traditional negative correlation between equities and bonds.
Monetary policy may now be falling out of favour, but fiscal stimulus is back in vogue, underpinned in the UK and US by infrastructure projects. When combined with a trend to restrict the free movement of labour, the takeaway from the Brexit vote and Trump’s election is clearly reflationary. Employment in both markets is already fairly full, so turning off the tap of labour immigration will likely inflate wages and prices.
With bond yields now rising across the board, it may seem that synchronisation remains firmly in place. However, if we look at the reasons behind this inflexion, I think it reveals something more telling, which points towards increasing de-synchronisation in future.
The political forces we have already mentioned are currently driving bond yields in the same direction globally, but we believe they will eventually cause greater heterogeneity of returns. If countries introduce frictions to international trade and the movement of capital and labour, then their economies are likely to diverge and the debt (i.e. bonds) of each country is likely to be increasingly assessed on the merits of its own economy.
This is one reason we will be taking an increasing international approach to our fixed income allocation. We have maintained our long-standing underweight position, but the asset class’ diversification benefits continue to justify an allocation in a balanced portfolio.
Investors now have to look to other means of generating income and low-volatility returns, with the options including real estate, long/short equity strategies and strategic bond funds.
Unfortunately, rising government bond yields are likely to have negative knock-on effects on other asset classes, all of which are ultimately to some degree priced at a premium to this risk-free rate. Even though their valuations look elevated, we are reluctantly tilted towards risk assets including equities and making use of managers with distinct and robust investment processes – who will, for example, be investing in companies resilient to inflationary pressures – and those that make use of innovative strategies, such as enhancing income through writing covered call options.
De-synchronisation and greater heterogeneity means an opportunity for active managers to add alpha through their ability to research and differentiate between investments. The days of making straight risk-on or risk-off trades may be behind us as we see less intra-asset and inter-asset correlations. We have already seen sector rotation away from defensives towards cyclicals, and the next step will be to observe greater differentiation at the security level.