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STATE OF AFFAIRS
Not a single person has ever experienced the exit path out of a global pandemic. A global pandemic that literally cuts through the developed (DM) versus developing (EM) economies divide. DM countries enjoy peak positivism as vaccination momentum reaches targets (US & UK) or will achieve 60% to 70% of adult population vaccination targets by July/August (continental Europe). EM countries remain mired in uncertainty and distress as infection numbers remain high (Brazil) or out of control (India). The biggest threat today remains the propagation of new strains that show immunity to the successful vaccines administered. However, hope springs eternal. That is reflected in financial markets to a degree not witnessed over decades. Market participants scratch their head as valuations of risk assets, from equity to high yield, reach lofty levels. Investors in risk-free government bonds have been intimidated for the first time since long. Intimidation is exerted by the deepening negative year-to-date performances across DM & EM government, aggregate or investment grade (IG) bond solutions.
The question we raise today is how to deal with such a condition? A condition that blurs the mind but is rarely high on objectivity. That is why I take a snapshot across defensive, balanced and dynamic portfolio solutions. Is there much to worry about? We focus on the bond component for each profile and provide straightforward advice. The share of the equity component will only serve as a guide to our duration profile.
Most defensive profiles with an equity share up to 20% still enjoy positive results since the start of the year. A rough estimate puts returns between 1.00% and 1.75%. Assessing the composition of the bond component reveals that the higher the content towards global multi-currency bond solutions or regional IG and high yield (HY) solutions, the better the result. Indeed, central bank purchase programs that included corporate bonds have made IG and HY sectors highly resistant in the face of rising core rates. The cyclical growth recovery has increased bond term premia and steepened core government yield curves, but, at the same time solidified corporate balance sheets. Companies were able to roll over debt at low funding cost or governments stepped in to provide guarantees or relief in refinancing plans. Global bond solutions suffered from ‘beggar thy neighbour’ currency depreciation but contained the damage. Four months have passed, and these solutions have seen their running yield rise handsomely. Global aggregate bond solutions offer yields between 1.25% and 1.75% depending on their DM/EM weights. Global EM debt solutions also fell victim to the rise in US long rates but boast healthy 5.00% to 5.50% yields at this juncture. Defensive profiles offer exactly what they were made for: capital protection. The only advice one might give is that defensive profiles should draw the global bond card. Main reason lies in the opportunity that such bond components possess in getting exposure to a higher number of independent bond risk factors from rates over credit spreads to currencies.
For the balanced investment profile, I take the traditional 60%/40% equity – bond portfolio. The majority of European solutions deliver robust 4.25% to 5.00% results over 2021. Most of the time the differences in result relate to equity exposure around the 60% marker. A balanced portfolio with 55% equity performs in the middle of the above range, whereas more aggressive solutions close in on 5.00% performance results. A rule of thumb goes that for each 10% of equity exposure, smart investors should seek 1 year of duration risk in the bond component. The 60%-40% balanced portfolio should allow for about 6 years of duration risk. It goes without saying that the added value from international diversification plays the same role in this as in the above defensive profile. In all honesty, the best advice one should give here is to do nothing and rebalance when you deem it necessary. The narrative that the 60%-40% solution would require replacement with other solutions than the above traditional bond component is discussable. The story goes that the negative bond-equity return correlation is on its way out. I repeat that positive bond-equity return correlation risk is present the moment aggressive tightening from monetary authorities goes along with unanchoring of inflation. We do not have evidence that we are falling into such a regime at present. Another argument against replacing traditional bond components with higher yielding alternatives might lessen your exposure to independent bond risk factors. Replacing traditional bond investments with private debt, hybrid credit or structured bond solutions could increase the overall correlation with your more volatile equity investments. The previous list of alternatives can, of course, be selected next to the traditional bond sectors.
Dynamic investment profiles go through the best-of-times. These solutions carry a minimum 75% equity weight. Over 2021 investors sit on about 7.25% to 8.00% returns. As we move into the month of May these investors might feel the pressure of the ‘Sell in May and go away’ narrative. To bond investors, this is an adagio that is very far from our thoughts about investing. For bond managers, liquidation costs and re-entry timing issues are important, but also impossible to answer. Timing in bond markets makes little sense. Full stop. As the anxiety of investors in the dynamic profile focus on the embedded equity risk, these investors should seek interesting positive convexity at the longer end of yield curves. Given the curve steepening witnessed over the past 4 to 5 months, picking bond opportunities in the 20-year to 30-year bracket of quality government or high-quality IG corporate paper, has become a luxury problem. When 30-year US government rates hit 2.5% end of March, smart investors might have engaged in such repositioning already. With 30-year UST at 2.30%, 30-year quality US IG corporates around 3.00% or Spanish 30-year government bonds closing in on 1.50%, the diversification benefits have not vanished. The advice for the dynamic profile is straightforward and relates to the call for an increase in the duration profile of the bond component. A bond component that should be as close as possible to the risk-free status.
Last weeks’ FED meeting did not surprise. If anything, Powell showed resolve during the press conference. He also confirmed that any threat of unanchoring of inflation and inflation expectations would not be tolerated. That mention was enough to lift inflation expectations across the break-even curve. 10-year inflation expectations rose to 2.425% on Thursday, closing at 2.405% end of the week. Last time markets witnessed a 2.42% level on 10-year breakeven rates was April 2013. Back then, effectively over May, we were jolted into the Bernanke bond tantrum, with 10-year US rates spiking 140bp from 1.60% to 3.00% by September 2013. During the tantrum, 10-year inflation expectations dropped back towards 2.00% and consolidated within 2.00%-2.20% till the summer of 2014 before dropping below 2.00% for the remainder of the decade. US bond markets are prepared for Average Inflation Targeting. US bond markets are also prepared for a bond taper in early 2022. The level of long-term rates will be shaped by the moment of FED fund lift-off. Frontloading lift-off will push up 10-year rates, delayed lift-off will put downside pressure on US long-term rates. 10-year rates ended the week at 1.62%. The upcoming week will drive another series of home-runs towards bond investors, as expectations for payrolls and PMI’s run high.
European Government Bonds (EGB’s) got smacked over the past week. The EGB sector dropped 61bp in value and retreats towards -3.49% over 2021. Intense ECB QE is an invitation for investor to lower their EMU government bond exposure. As little impact it might have on financial conditions for core EMU countries, the rise in funding costs for the periphery is not a positive evolution. Before long, investors might become unnerved, yet again, whereby upside rate pressure for Italian, Spanish, Portuguese governments becomes more than a footnote. In the meantime, we expect Next Generation EU funding to kick-off in July. The ECB balance sheet will stand ready and commit for a decent start.
The resilient bond sector by excellence only retraced by about 16bp. European IG corporate bonds limit the blow over 2021 showing a -0.91% print. Primary activity will ramp up over May. Overall attractiveness of the sector is improving alongside the adjustment in European core rates.
European high yield was fully insulated and climbed 15bp over the week. Positive results of 2.22% over 2021 is attracting more investors towards the sector. HY credit spread volatility is low. Risk parity and other volatility-based investors increase their allocations to risk assets.
The yield of EM local government bonds (JP Morgan GBI EM GD index) rose by 6bps over the week, in line with the move on 10-year US rates. The index yield sits at 4.93% versus 4.22% at the start of the year.
Most commodities, boosted by optimism of a quick global recovery, have enjoyed strong momentum and returns. Copper breached USD 10,000 per tonne, while gold became the main laggard over the week. The surge in copper prices is weighing on industrials in China. Several Chinese manufacturers of electric wire have to halt deliveries or are in the process of defaulting on bank loans according to a survey by the Shanghai Metals Market. Chinese economic indicators like the Caixin and PMI series are diverging. Chinese Manufacturing PMI fell to 51.1 in April (from 51.9 in March), lower than the median estimate of 51.8. While the overall picture shows the economy continues to recover steadily, such indicators warrant a bit of caution on the role of China as the engine of global growth in the coming year.
Newsflow on the COVID front in India is getting worse, with rising test positive rates and intense strain on ICU beds availability. The reproductivity rate is above 1.5 for the country with some states breaching 2.0 levels while the vaccination rollout is slowing. The US has committed to send 20MM AstraZeneca doses to the country. The Indian Rupee had been initially hurt by the deterioration of the economic outlook in the country. On top, rumours circulated that the RBI central bank officially considered quantitative easing. By the end of the week the INR stabilized around 74 versus the USD. The INR has been one of the worst performers in terms of spot returns versus USD (-0.95%) while the ZAR has been one of the best performing currencies (+3.03%). EMFX valuations and bad news on the direction of COVID cases show high short-term correlations.
As we enter the month of May, market participants might exhibit some erratic behaviour based on volatile rules of thumb. However, for well-diversified investment portfolios, there is no reason for panic. On the contrary, a sound bond-equity diversification will allow for a smooth return profile going forward.
Sell-side agents are calling the end of the traditional portfolio construction. However, the factual results speak differently. If anything, calling for more rotation activity is serving their results well, as pointed out by the stellar Q1 numbers coming out last week. Banking models require higher fee-based income. Beware of the messengers in this field.
As we are moving into the last phase of the COVID pandemic, financial markets will start to ‘value’ the world post-COVID. How much of our behaviour will have been changed? Lots of questions and related uncertainty remains at present. Cherish your bond component across investment profiles.