End of an era

We have long talked about the benefits of diversifying your bond assets (as well as your broader asset pools) and about trying to avoid being exposed to index benchmarks. Listening to market experts right now could leave you convinced that bond market Armageddon was around the corner as extremely accommodative monetary policies are reversed.

That said, which assets will be most affected? Government bonds or high yield corporates? Investment grade or emerging markets? As you can see in the table below, these asset classes provide some very different outcomes at different times of any cycle. Finding the right one or optimal blend for the environment is the key.

Percentage total return from asset classes

Percentage total return from asset classes

Source: BAML indices

Even in the past few years when, we are told, “everyone has made money in bond markets” some asset classes have delivered negative returns, despite the positive impact of quantitative easing on returns. As policymakers withdraw these extraordinary policies we have to think about which asset classes are vulnerable during the wind-down and whether the next slowdown in growth is going to follow.

Is this time different?

Using the past as a road map to the future is always a tempting activity and indeed there are many good reasons not to expect a difference “this time” with anything. However, this time it IS different to any other rate cycle since the Second World War.

Inflation is the clear difference compared to previous cycles. It has yet to emerge as a threat – one to which the central banks would respond by hiking interest rates aggressively in developed markets. With the amount of debt still in the system in these economies, a natural dampening effect on inflation may even occur (debt can be thought of as growth pulled forward from the future as it needs to be paid back!!). If this remains the case, it will undoubtedly become the longest hiking cycle ever but even then the terminal rate is only likely to be around the 3% level built in to the last Dot Plot.

On the other hand, the experts could be wrong. Just as everyone starts to think about inflation remaining suppressed for ever, de-globalisation, trade wars and tightening labour markets could all contrive to give us higher prices.

The slow pace of rate hikes is also a reflection that central bankers understand this debt dynamic, and that economies remain over-levered and fragile. If policy rates do go up more than is currently priced in by the market, we do know that treasury yields are likely to rise sharply, taking other high quality instruments with them. Away from that, most major asset classes normally perform well through rate hiking cycles - but this time we have an environment where, although economies appear to be gradually improving, debt levels are elevated.

Policy measures themselves have also been very different this time relative to history. Central banks like the US Federal Reserve and the European Central Bank bought vast quantities of bonds to force volatility down and make other asset classes more attractive. We know that over the coming years they will reverse these policies, meaning that private sector demand will have to take up the baton. The potential impact of this policy unwind has, along with Italian politics and escalating trade wars, troubled markets in 2018, causing spreads to widen and most equity markets to fall.

Many commentators are on the look-out for the next slowdown

When will it all go wrong?

Now we are well into the hiking cycle many commentators are on the look-out for the next slowdown. A slowdown invariably follows a hiking cycle and the timing and severity are the crucial things for us to consider from here. Most alarming for many is the level of debt at the corporate level and the suggestion that this will be the next source of a crisis. The deleveraging of the financial sector has come with a cost – the re-leveraging of others.

As can be seen in the chart below, the corporate bond markets have grown considerably since the crisis. This itself could be a danger, especially if policy rates and refinancing levels rise excessively. It is not, however, fair to compare this to either the 2000/2001 telecom bubble where over-indebted companies failed to grow fast enough, or the financial crisis where the housing downturn led to the near collapse of the financial system. Defaults are likely to rise, especially if profits (and the ability to service more expensive debt) fail to keep growing.

Global debt has grown from $97 trillion to $169 trillion since the crisis

Total debt outstanding ,
$trillion, constant H1 2017 exchange rate

Source: BIS, McKinsey Country Debt Database. McKinsey Global Institute analysis

So what can we conclude?

One of the recurring themes from any late cycle market (including this one) is the rise in volatility during the early stages of a hiking cycle. There is also good reason to believe history will be correct in that risky assets still have room to perform well in these early stages.

As we move into the middle and end stage of this elongated hiking cycle, growth will start to come down, yields will rise (unlike a normal slowdown) due to inflation rising without the dampening effect of QE, and eventually defaults in riskier credits will start to rise as well.

Staying flexible with asset allocation in terms of asset classes and geographic exposure whilst having access to a wide and deep pool of analysts for stock ideas will lead to the best result during what will seem like a tumultuous few years. For the last 10 years relying on the market beta has been a decent strategy, as higher volatility stocks tend to do well when the market is rising, but going forward one needs to have access to expertise!