As markets face central bank quantitative tightening (QT), there are signs that we are on the brink of a regime change across major asset classes.
In this article, we explore some of the shifting sands in the macro/market backdrop and the implications for cross-asset investors and asset allocators.
Fixed-income markets: brace for impact?
US interest rates
Changes in the yields of US Treasuries (USTs), the ultimate risk-free instrument, potentially have major implications for the valuations of many asset classes. In 2018, 10-year UST yields broke out of their multi-decade downward sloping yield channel established since the mid-1980s.
Exhibit 1: 10-year UST yields have broken out of 30-year bull-trend
Source: Bloomberg and BNP Paribas Asset Management, as at 26/10/2018
The break higher is occurring at an interesting juncture:
- Higher yields are consistent with still-strong US GDP growth
- Expansionary fiscal policy means a higher deficit and increased issuance; investors will require a bigger premia
- Foreign buyers of USTs may be harder to find since currency hedging costs have risen vastly
- Higher Federal Reserve policy rates may eventually weigh on economic activity
- Abnormally depressed term premia could finally revert back to normal.
All of this leads us to expect structurally higher rates for the medium term.
While UST yields are at new highs above their 2013 taper tantrum levels, German Bunds are still below those levels. That said, the correlation between USTs and other fixed-income markets has remained high. So, the other markets should follow USTs, especially given their high valuations.
Higher yields and equities: shifting correlations?
The correlation between stocks and bond returns was negative in the last two decades. But this has not always been the case. Before the mid-1990s, correlations were positive (Exhibit 2).
Exhibit 2: Equity/bond correlation mostly negative since mid-1990s (S&P 500 vs. UST weekly return correlation)
Source: Bloomberg and BNP Paribas Asset Management, as at 22/10/2018
We find that low and anchored inflation may be one of the causes for this negative correlation. But the question of what ultimately drives yields higher in the first place, and how sharply the fixed-income sell-off is, matters too. If yields rise in response to a better economy, and this comes with better company earnings, yields can rise and equities can rally in tandem.
However, when yields rise, causing stocks to sell off, and yields then recede only briefly, as happened in the October 2018, correction, this begs the question whether bonds are still a good hedge. Unfortunately, our analysis suggests the answer is ‘no’. In the current cycle, yields tended to rise as equities have suffered, signalling that the equity/bond correlation may be turning positive.
This is worrisome, especially in the face of likely larger equity corrections when we eventually hit end-cycle. If bonds cannot hedge smaller setbacks in the bull run, how can they be portfolio hedges when stocks enter a bear market? While in such a scenario, a safe-haven bid may propel bonds, the low starting point of yields means that bonds will be worse hedges.
To illustrate this, 10-year yields would need to fall by more than two percentage points to around 1% to give a return of 20% that would match the average historical equity market sell-off. In fact, equity sell-offs have been clearly bigger in some recessionary periods.
Other implications for asset allocators
The shifting macro/market backdrop will, in our view, set other challenges for asset allocators.
- Volatility should generally rise, particularly given that QE has been a big contributor in depressing market volatility in recent years.
- With valuations looking more stretched and no central bank put underpinning markets, return expectations should be much lower for the foreseeable future.
As correlations across asset classes shift, individual assets are likely to revert to being driven by their own fundamentals/news. This unwinding may already be under way.
Strong US growth, expansionary fiscal policy and increased bond supply, Fed monetary policy moving into restrictive territory and higher real interest rates and term premia should keep US rates in the ‘driving seat’, potentially affecting valuations in many asset classes. With bonds the source of equity sell-offs, they now offer less protection to cross-asset portfolios.
As a function of the shifting macroeconomic sands, we are likely to see lower returns than those during the height of the QE era, and importantly, more volatility. Sharpe ratios for buy-and-hold investors are thus likely to be much lower than in recent years.
For us, this means being ever more tactical in managing portfolios and suggests a return to an environment favouring ‘asset pickers’ where portfolio managers can again add more alpha.
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