Inflation is back. It’s been four decades since investors have had to take soaring prices into account, and it’s upending traditional methods of diversification and multi-asset investing.
The long-held, favourite portfolio allocation of 60/40 equities to bonds has been found wanting; with both bonds and equities losing value at the same time, investors can no longer rely on bonds to provide diversification benefits against equities.
Could we see a resurrection of the humble bond over the next 12 months?
We believe so. Indeed, we’re on the lookout for the right signs to increase exposure – while remaining mindful that timing could be everything. The road towards portfolios once again fully loaded with bonds is likely to be a bumpy one. In fact, there is so little clarity on the eventual macro outcome that you could compare this journey to driving at night, in a storm, with no headlights. The situation is incredibly volatile. Factors including geopolitics, monetary policy and supply-chain disruptions could turn on a dime, leading targets to overshoot (or undershoot).
What indicators are we looking for along the way?
As Mark Twain said, “History doesn’t repeat itself, but it often rhymes”. We can therefore look to the past to guide us on current decision-making. When the Federal Reserve (Fed) previously raised interest rates, we tried to establish at which point bond yields would stabilise during each cycle. Going all the way back to the 1980s, evidence shows that you had to get a fair way through a rate-hiking cycle before bond yields peaked.
We don’t expect rates to hit the giddy heights of the '80s.
How long do we think this rate-rising cycle will continue?
We estimate a hiking cycle that is not too different from what is currently priced into markets, although the distribution around this can be quite wide. It could be late summer, after a few more 50 basis point rate hikes, before we feel comfortable that we’re entering the final stages of the Fed’s hiking cycle. It could be sooner, it could be later – we’ll have to wait and see.
We’re also looking at a number of growth and inflation indicators to give us comfort that growth is slowing meaningfully and inflationary pressures have peaked and are rolling over.
On the growth front, we’re closely monitoring the Institute of Supply Managers Index and the Citigroup Economic Surprise Index. As for inflation, we’re hoping to see core inflation (rather than the headline number) drop to more typical levels. This may signal an end to Fed hiking and more certainty that inflation is peaking. Right now, inflation is a real challenge. We’ve not seen these levels since the 1970s and ’80s, and we want signs that a wage-price spiral is not on the cards.
We’ll also want to see bond yields hit our own target levels before we start rebuilding holdings. That said, we won’t solely rely on these targets and instead combine them with the fundamental waymarks highlighted above.
Is there a danger of interest rates going very high?
At this stage, it’s possible. But due to the amount of debt in the economy, we don’t expect rates to hit the giddy heights of the '80s.
Further, while yield levels are important, the rate of change in yields is equally significant. Consumers, corporations and governments will have a rate in mind at which they expect to repay their debts. Any sudden change to that rate could significantly affect all kinds of decisions, from spending to investment.
So, for now, we’re checking the tyres, fuelling up and preparing as best we can for the unknown journey ahead.