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Time has come to put asleep some persistent messages surrounding the supposedly uninvestable nature of fixed income markets. Not a day goes by or we read that central banks have pushed € 8, 10 and today 15tn+ of bonds into negative yield territory. Or, investors should avoid the fixed income universe as you lock-in a negative return. Not only are such statements misleading, as bonds in a global diversified portfolio context still offer decent returns, but it refrains investors from obtaining a correct bond exposure profile. The danger lurks that it weighs on their strategic and/or tactical asset allocation decisions. We start by looking at past returns in order to provide an objective answer to the question: “Why buy bonds?”. Our response today, still is, “Ask again!”. The capital preservation and growth characteristics have all but gone in bonds even with an increasing amount of negative yielding issues.
Bond returns driven by imbalances
In the table & chart below we publish realized net returns YtD and over 3yr and 5yr rolling across a subset of our fixed income solutions.
Source: DPAM, August 2019
Two observations stand out. First, over the past 5 years € Government bonds outperform € Investment Grade bonds. Second, it handsomely paid off to invest globally next to allocate correctly into the specialist High Yield sector. We also debunk the idea that central banks are responsible for this bond bull market. The underlying root cause for the unrelentless drop in long term rates is the structural imbalance between investments and savings across public and private market participants. The balance sheet deleveraging that started in 2008/2009 is still humming along across governments and corporates. Banks stand out in this field. This has resulted in a steep drop in expected bond returns. However we do not see many catalysts that counter this momentum. On top, if we would get ‘lucky’ to see a back-up in expected returns as long rates rise we should expect buyers who missed the initial bond surge to surface quickly. What set of conditions might lead to higher long term rates ? The answer is a combination of increased investment spending by public authorities, DM central banks lowering real policy rates and an improving remuneration of the labor factor. That requires visibility and confidence in global growth. Both are blurred today.
Responsible central banks vs. competing (irresponsible) governments
Clearly, we witness an unraveling of multilateral institutions and the advent of protectionism in key DM economies. In a rising number of G20 countries, state leaders achieve higher political return by promising better times ahead for the left behind electorate. Unfortunately, as they aim to lower inequality their end result might be higher inequality as less growth will negatively impact the ‘have not’s’ first before it impacts the top decile of the income distribution. We have no other choice than to count on responsible central banking policy. DM central banks will lower real policy rates further in order to stir investments and discourage the liquidity trap. The latter pushes rates lower and more negative. We expect the ECB to introduce QE 2. This will improve the external competitive position of the EU versus its trading partners. QE 1, with money supply rising 25%, led to a depreciation of the EUR versus the USD of about 25%. Notwithstanding QE 2 will suffer from diminishing impact we still expect EURUSD to retest 1.07 (-5% from August 2019 highs) and possibly even previous cycle lows of 1.0340. All depends on the expected increase in EMU monetary base as a result of renewed asset purchases in government bonds and corporate credit. The indirect impact on broad money supply (M3) is the key determinant to measure the impact on the value of the Euro currency. The rule of thumb concerning the main EURUSD currency pair is that a program that raises the money supply by 5% should turn into a 5% depreciation of EURUSD. An asset purchase program that increases the monetary base by 40bn to 50bn per month over a 12 month period should result in an expansion of broad money supply by at least 5%.
A global policy rate cutting cycle started a couple of months ago in Australia and New Zealand. The Fed joined the party end of July and will accelerate policy accommodation over next 12 to 24 months. The end point is uncertain, the direction is not. US policy rates are expected to drop towards 1.00% over the next 12 months. The FED will not disappoint. The question is if markets start to price in 0.50% or even 0.00% FED policy rates? A combination of both scenarios turns the intermediate part of the US Treasury yield curve attractive, possible even more in real rates (US TIPS). In Europe we value EMU real government rates. The risk profile of deeply negative nominal rates is suboptimal. The ECB must lift overall inflation expectations. The Swedish Riksbank succeeded in this by, among other actions, lowering deposit rates towards -1.25%. The Swedish real curve is flat with real rates around -2.30% at the 10 year spot. Today, German, French and Spanish real rates fluctuate around -1.60%, -1.35% and -0.95% respectively. The EMU market based inflation expectations across maturities and countries sits at a shallow 0.90%. The ECB can claim victory the moment this key indicator goes beyond 1.50%. Above 1,75% their credibility gets restored.
How to position in bonds?
We have to play the same broken record. There is no golden portfolio construction as investor expectations and risk tolerance differ. We recommend diversifying across DM and EM sustainable government bonds, issued by countries that hold democratic values and human rights in high regard. Select quality corporate bond issuers in IG and HY space that have a successful track record in rolling over their balance sheets across credit cycles. We clearly observe that dispersion is rising as recessionary conditions come closer i.e. the number of country and company specific credit events increase. Central banks will guarantee that liquidity provisioning remains supportive for solvent issuers. The objective to obtain stable financial conditions is the silent goal that central banks want to achieve.
We repeat that selection of underlying bond strategies is as important as the correct positioning across bond sectors. Flexibility is a characteristic that we value across actively managed benchmarked and unconstrained strategies. We invite investors to focus on those choices and not on how negative that nominal rates can go. Nor in trying to assess how long we will be confronted with negative nominal rates. Today (August 19th), the market answer is that the 1 month EONIA rate (overnight interest rate) 5 years forward sits at -50bp! So do not expect a miracle return over next couple of months or even years. For completeness, we add expected bond returns across main indices from DM over EM government bonds and IG to HY corporates across EUR and USD. Avoiding international diversification is opting for trouble. Good sailing in these low yield waters!
Source: DPAM, August 2019