Fixed income markets continue to face a rather dire backdrop. Bond yields are still negative in Germany and Japan and this is creating significant headwinds for future returns. Most critically, valuation pressures continue to mount in many key markets, creating a growing sense of caution that is both prudent and warranted.
This became more evident as yields plunged into negative territory through 2016. During this time, there were many comments about bond bubbles and analysis of what the catalyst could be for a sharp reversal. We also saw warning signs, with negative return expectations across every asset class except emerging market and high yield debt in the aftermath of Brexit. This also caused us to favour cash over bonds as a means of protecting capital.
However, it creates an interesting predicament from a portfolio construction perspective. Diversification is at the heart of risk management for many investors, including us. The simplest way to think about diversification is to picture offsetting gains and losses on investments in a portfolio.
However, fundamentals must also drive diversification at the asset class level. Corporate profits supply the returns from equities, as coupons do for fixed income. In an ideal world, we would desire assets that offer both positive long-term return expectations and negative correlation benefits. Yet, the dilemma comes as valuations become stretched, because we know we cannot rely on an expensive asset to improve overall reward for risk.
Valuation Must Drive Investment Choices
At the heart of this decision is the fact that in the very long-term, buying overpriced assets as a means of achieving diversification is an inefficient use of capital. The most important inputs should be valuation and fundamental risks, at both the asset and portfolio level, as these drive the variation in long-term returns.
Ultimately, cash becomes a valid solution, and while it does not add anything in absolute terms and it will act as a drag in real terms, it provides ammunition against any future unwinding of these overvaluations. In this sense, we take comfort from Warren Buffett’s quote, “Cash combined with courage in a crisis is priceless”.
Will Inflation Cause a Bond Market Crash?
There appear two likely catalysts to a shock in fixed income markets, defaults or inflation, but they would have contrasting impacts on returns.
When it comes to default rates, the backdrop is supposedly improving rather than deteriorating. In fact, Moody’s now forecasts U.S. default rates to decline from 5.7% in 2016 to 3.8% in 2017, while Europe default rates are supposedly set to remain at a very low 2.1%.
We believe investors should not accept this view unchallenged and could be potentially served by applying a longer-term memory to the situation. To our longer-term thinking, it seems intuitive that the underlying risks might actually be increasing despite the fact default rates are ‘forecast’ to decrease.
Unlike higher risk fixed income, government debt is not usually subjected to the default risk cycle in the same way. While governments can, and do, default, government bonds tend to benefit from a ‘flight to safety effect’ during times of distress as investors shun riskier alternatives. This is especially true for long-dated U.S. Treasuries or U.K. gilts, which both typically receive inflows during periods of economic concern.
The greater risk to government debt holders is an unexpected and persistent rise in inflation. Higher inflation erodes the real value of the bond and consequently reduces its attractiveness to investors. This in turn tends to result in lower bond prices and can result in a permanent loss of capital.
The problem for investors is that these inflation shocks are both largely unpredictable and can arise from a diverse range of factors. As with other such risks, we therefore need to adopt a probabilistic approach to considering the risk of an inflation shock.
When doing this, one of the key considerations must be the starting conditions. In an environment of stable prices where central bankers are focused on promoting inflation rather than suppressing it, the potential for a future inflation shock is necessarily larger than when the opposite conditions prevail. Second, we must consider the role of money supply.
Milton Friedman, the father of monetary economics famously stated that “inflation is always and everywhere a monetary phenomenon”. However, when we examine the supply of money there appears to be a disconnect between this statement and the current stability of prices.
For example, we can see that the U.S. has aggressively increased the sum of all currency held by the public, since the financial crisis. In fact, the OECD report the Federal Reserve have increased this narrow money supply by more than 10% per year or 144% in total. It still runs at 8.8% today. Theoretically, economists tell us this should usually transfer into higher inflation as there is more money chasing a similar amount of goods and services.
However, we know this has not happened. Some attribute the resulting lack of inflation to a decline in the speed with which money moves around the economy. However, it is important to remember that the velocity of money is very difficult to measure and is traditionally a ‘plug’ number to make the monetary equation balance rather than an observed metric.
While economists will continue to argue about the reasons behind the lack of inflation, investors need to be aware that the link between money supply and inflation has been strong in the past and therefore poses a risk in the future.
How Can Investors Act?
The lesson is that market expectations can change quickly, but so can policy stance. The message must therefore be to expect the unexpected and focus on what a reasonable inflation rate would look like in the very long-term. In this sense, we believe it is hard to go past a common-sense approach using the central bank inflation targets rather than trying to pull solutions from the sky.
An extension is our assessment of inflation-linked bonds. We tend to monitor the break-even inflation rate – the difference between the yield of nominal bonds and inflation-linked bonds – and have witnessed an increase in recent months as market expectations shift. However, we continue to see significant segmentation due to the duration of these bonds. This leads us to favour U.S. TIPS, treasury inflation-protected securities, as a means of providing protection against an inflation spike.
