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Investment Institute
Point de vue : CIO (en anglais uniquement)

Adieux à la reine

  • 16 septembre 2022 (5 minutes)

It’s been a momentous week. The Queen has sadly passed away and the UK is excelling at putting on a dignified public celebration of her life and rule. The era of her sovereignty ends with a new era in the global economy and financial markets – the post-QE era. Interest rate increases are continuing because inflation has become stickier. It is a difficult investment environment as losses of wealth hurt alongside a higher cost-of-living. One outcome is higher bond yields. To offer some good news, there is a better risk-return profile going forward for fixed income. Bonds can again be a good hedge.

Sapienta et Doctrina Stabilitas

The enormity of the passing of Her Majesty, Queen Elizabeth the Second, cannot be stressed enough. For Britons, it marks the end of an era and provokes deep reflection about both our history and our future. For many of us, it was the constancy of her role as Sovereign – something that was taken for granted, cherished and comforting. It was the fact that she was above politics – a characteristic necessary to have had to deal with fifteen British prime ministers from both sides of the political divide and to stand face to face with numerous world leaders over the decades. She was there through changing, troubled and glorious times. Her death has provoked questions over the role and even the very existence of the monarchy. The event is global like no other event could be.

Reset

Like the British monarchy, the bond market will outlive us all. Yet, I read analysts questioning the role of bonds in an investment portfolio when we are in an inflationary world. It’s true that returns from fixed income have been awful this year but the incredulity with which this is viewed is symptomatic of the “living in the moment” conditioning of many commentators in the financial markets. Bond returns are negative because interest rates have gone up from levels that we all knew could never be sustained. If you go through an extraordinary period in markets – defined by unparalleled central bank interventions – then it is ridiculous to expect an immediate return to normality. The last year has been about re-setting the risk-free rate, the overnight interest rate. That process is clearly not over yet.

6% core inflation not acceptable

The August consumer price report in the United States confirmed that. The annualised rate of core inflation over the last six months is running at more than 6%. That is unacceptable to the US Federal Reserve (Fed). The inflation picture is more than just energy now as the pace of price increases is high amongst many non-energy goods and services. At the same time the labour market is very tight. I was in the US last week and every conversation was either about not being able to hire or about how prices, rents and wages were going up.

The end is postponed

The Fed will keep raising rates until it gets squeamish or there is evidence of something cracking – jobs, growth, housing or the markets. The market has 4.5% as the peak now and some economists have raised their forecasts accordingly. But it could be 5% or 6% – who knows at this stage. Part of the motivation for additional hikes is the fear of losing credibility, which would result in long-term inflationary expectations moving higher. So far that has not happened and the most recent survey of consumer expectations published by the Federal Reserve Bank of New York showed a further rolling-over of both 1-year and 3-year inflation expectations. The same is seen in the inflation-linked bond market.

Rate hikes end expansions

It’s the uncertainty that kills investment performance. Monetary policy acts with long and variable lags on the real economy and we don’t know yet what impact the hikes to date are going to have – a statement that holds not just for the US but the UK, the Euro Area and all economies that have raised rates this year. Global monetary conditions have tightened, global real incomes have been squeezed. A global recession looks increasingly the result. 

Bonds live

So what to do? Apparently the 60/40 investment model is dead because bonds and equities both went down together in the first half of the year. The Pavlovian response in markets is to think what just happened will happen again (until something else happens of course). But indulge me with bonds for a moment. We have higher yields. Because of that, the hypothetical return profile has changed. If a bond yields 1% and has a duration of 7-years, a 1% rise in yields will deliver a total return (over a year) of -6%. It’s very unlikely that yields would fall by 1%, but if they did the total return would be 8%. But at low yields – where we were in 2020 for example – the risk is more skewed to yields going up.

By contrast a bond with a yield of 3.5% would see a total return of -3.5% should yields go up by 1% and a total return of 10.5% should yields fall by 1%. It’s clear that with higher yields – today relative to any period over the last 10-years in the US Treasury market – the risk-return profile is superior. This has been delivered by a tightening of monetary policy. To me that strengthens the case for multi-asset investing – having bonds alongside equites today gives more diversification than it did two or three years ago. Using the simple numbers above and assuming that interest rates are approaching a level whereby the expectation is that they could be cut in an economic downturn, the bond allocation could hedge a large part of any losses in equities in such a downturn.

Upside risks

If central banks keep on raising rates, the odds of a recession shorten. That means yield curves will flatten or invert further unless medium term inflationary expectations do become un-anchored. Flatter or inverted curves mean bond yields go up less than overnight interest rates. So the Fed might take the Fed Funds to 5% or 6% but will Treasury yields rise another 300 basis points? I doubt it. If they did, the outlook for stocks is even worse and clearly if that was the message from the Fed, short-duration exposure in fixed income, to capture the increased carry, would be the only sensible strategy until rates did peak. But if the market is right and 4.5% is the peak then longer duration fixed income assets starts to look more attractive in a diversified investment portfolio.

By extension, corporate bonds have a similar risk-return profile with the additional risk that returns could be compromised by the positive correlation between spreads and equities. Yet I think credit has priced in more of a difficult environment than equities, certainly in the US where spreads in investment grade bonds are towards the top end of the trading range of the last decade, while equity multiples have gone back up again since the early summer. One could argue that credit spreads are only consistent with a soft landing rather than a sharp recession, but US equities are hardly pricing in any interruption to growth or earnings. Again, for credit, it’s the carry that is attractive with yields above 5% for investment grade and around 8.5% for high yield.

A lot already

Bond yields can clearly go higher and the next event is the Fed meeting on the 21st of September. The size of the interest rate adjustment and the comments from Powell will impact trading sentiment. If rates rise by 75 basis points (bps) that will be a cumulative 300 bps of hikes so far. That is aggressive by the standards of previous cycles in a relatively shorter space of time. After a 75bps hike, there would be only two cycles since the mid-1980s in which rates went up by more – 1988/89 and 2004/07. Both resulted in recessions. In the final years of those cycles, Treasury returns were 14% and 9% respectively.

Monarchical glory, cheap currency

Finally, returning to the UK and an observation about UK equities. They are cheap and if you are non-sterling based, they are very cheap. The FTSE 350 is trading on less than 10 x 12m earnings. The pound is less than 10c above its all-time low versus the dollar (and as I write it is the 30th anniversary of sterling exiting the European Exchange Rate Mechanism (ERM) – the dollar/pound rate at the time was above $2!). Yes, there is policy uncertainty with a new government about to take control and the economy is weakening, as shown by the slide in retail sales in August. But policies are likely to be pro-growth and we will soon get details about the size of the intended fiscal package. The value in equities is not in the top 100, but in the small and mid-cap areas which continue to see mergers and acquisitions activity (M&A). If a floor can be put under growth by government fiscal stimulus, there may be more bargains to be had.

Markers

In a car in Sheffield. On a beach on Long Island. In a taxi to Heathrow and in a sushi restaurant in Greenwich, Connecticut. These are the places I was in when I heard of the deaths of Elvis, Princess Diana, David Bowie and the Queen. These things stick with you and help decorate the tapestry of memories. A new era dawns for the UK, for both the body politic (with our third female prime minister) and for the monarchy. Welcome to the Carolean era. The Queen is dead, Long Live the King.

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