The period of aggressive monetary policy tightening is moving closer to the finish line, with a new regime in fixed income markets set to begin.
These transitions can often be challenging for investors, so we have identified three key themes to consider and share our ideas for how to navigate this new market paradigm.
Unlikely to be a smooth transition
Defensive interest rate strategies have worked well for more than a year, but the need to continue with such an approach is receding. Central banks are moving closer to the end of their hiking cycles and most are expected to finish over the coming months.
We expect heightened volatility in bond markets before central banks pause rate hikes
At the same time, inflation is easing – albeit slowly – and growth is showing signs of weakening, particularly on the manufacturing side.
Transitioning from a hiking environment to a pause environment is never just a simple case of moving from a short duration posture to a long bias and remaining there. A lot happens along the way – and this regime change will be no different. We expect heightened volatility in bond markets before central banks pause rate hikes.
In terms of portfolio approach, we believe managing duration actively will be critical to navigating this transition. An active approach facilitates tactical responses to different market climates and regime changes, while also providing the flexibility to take advantage of pricing anomalies and dislocations.
The UK needs to sell more than £240bn worth of gilts in the 2023 fiscal year, the second largest on record
Taking advantage of the broad investment universe is also important. It offers opportunities to capture value resulting from monetary policy dispersion. Central banks are approaching the end of the cycle at varying speeds – emerging markets are the furthest ahead and bond yields are starting to fall there now, particularly in Latin America.
Higher rates and risk of volatility
Across the globe, government spending has increased materially in recent years due to the pandemic and various schemes to help citizens with the higher cost of living.
Debt-to-GDP levels have risen, and greater government debt issuance will be needed to help finance the higher deficits. However, this comes at a time when central banks are no longer supporting markets with quantitative easing, which means they will not be mopping up the increased supply as they have done previously.
We believe the negative stock/bond correlation will make a return
Demand will need to be met entirely by the private sector, which could anchor rates at higher levels than past cycles.
It is important to note this is on a country-by-country basis, with some more impacted than others. The UK, for example, is one country that stands out as it needs to sell more than £240bn worth of gilts in the 2023 fiscal year, the second largest on record.
Debt issuance also needs to rise in the US. We believe this will drain liquidity from financial markets and ignite volatility in risk markets such as credit and equity. This backdrop adds to our already cautious view on the outlook for risk markets, where we believe there is potential for corporate fundamentals to deteriorate amid the challenges of slowing growth and higher debt servicing costs.
As for a portfolio approach, an active approach to country selection is important in this environment, as is curve positioning, especially as the countries that need to raise more debt may target different maturities. Given the concerns around the risk environment, a defensive approach may also be warranted as hedging strategies can help to navigate volatility.
Potential return of stock/bond correlation
A key pressure point for investors last year was the fact bond yields rose while stock markets were selling off. This went against the traditional tendency for fixed income to be a diversifying asset class that should perform well when equity markets decline. Inflation, and the sheer number of hikes aimed at taming it, were the main drivers of this positive correlation.
It is important to be agile and choose hedging tools that are appropriate for the environment
But with inflation easing, albeit from a high base, and the end in sight for central bank tightening, we believe the negative stock/bond correlation will make a return. However, it is unlikely to be as stable as the post-financial crisis era, given central banks are no longer supporting markets.
In terms of portfolio approach, it is important to be able to adapt to the risk environment and not to assume the stock/bond correlation will always work.
For example, if there is an extreme market event that puts major selling pressure on risk assets such as equity and credit, we expect duration to be an effective diversifier. However, this will likely not work if the cause of the sell-off is bond yields themselves.
Against this backdrop, it is important to be agile and choose hedging tools that are appropriate for the environment. In some instances, this may mean using currency and derivatives markets instead of duration to help to balance and mitigate risk.
