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There were a number of key factors that contributed to the performance of fixed income in 2018. The US was a key driver and it was a tale of two halves. In the first half of the year, the US economy was operating at full potential with economic growth of between 3% and 4%. Yields on bonds were rising, inflation was picking up, and the Fed was lifting interest rates in line with inflation. This saw US yields rise modestly and we were positioned for this, being both short US duration and holding some specific trades to benefit from rising inflation. In this environment corporate bonds also performed well. Things turned sharply towards the end of the year with a slew of concerns around trade policy, the US midterm elections and a collapse in the oil price contributing to some big falls in equity markets. In this environment investors sought the safety of bonds, which saw bond prices rise and yields fall, boosting bond returns.
In Australia this, coupled with concern over house price declines, also saw bond prices rise and yields decline, boosting returns to investors from holding Australian bonds.
Our positioning saw the Schroder Fixed Income Fund (Wholesale Class) deliver strong absolute performance of 4.0% (post-fees) for the 2018 calendar year. Performance of fixed income both here and overseas was also strong and indicative of investor sentiment, wary of what would happen in the share market.
While that was then and this is now, many of the factors that supported bonds though the later part of last year are still in place. We expect growth both in Australia and in the key US market to remain softer for a while and the volatility that became a feature of 2018 will remain. Markets are likely to be disrupted by monetary policy adjustments and geopolitical factors. Volatility should create opportunity for managers to capture additional returns both through managing this interest rate volatility and through actively managing credit as the reward for owning credit ebbs and flows with this volatility.
This rising uncertainty in markets is serving as a potent reminder that bonds have an important role to play in portfolios. And, if economic conditions worsen and key economies track towards recession, bonds will likely be the place to be. In fact, our recession indicators suggest the odds of a US recession in 2020 are rising. Coupled with stretched valuations and macro uncertainty — trade wars, the end of quantitative easing, rising inflation uncertainty, and geopolitical risk — we believe fixed income will become increasingly important as an asset class. This is primarily down to the fact that in stressed environments or a recession, interest rates fall and bonds tend to outperform shares – generally significantly.
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