Thought Leadership

Reassessing fixed income - is Goldilocks about to give way to the three bears?

Bob Jolly

Bob Jolly

Head of Global Macro

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Interest rates are rising, while quantitative easing (QE) is slowly turning into quantitative tightening (QT).

In this new world, investors will justifiably want to know what the future holds for markets and what type of manager they should use to navigate the changing investment landscape.

Is Goldilocks, the recent economic background that’s not too hot and not too cold, about to give way to a three-headed bear market for bonds as rates rise, inflation climbs and volatility returns? Probably not, but investors may still need a different sort of manager. Here are a few reasons why.

For much of the last five or so years, all assets have been helped by the measures taken by central banks to fend off economic shocks in the wake of the Global Financial Crisis. The flood of liquidity provided by quantitative easing (QE) alongside record low and, in some places, negative interest rates has tended to lift all boats.

Not surprisingly perhaps, fundamental analysis has been usurped by indiscriminate buying of everything and anything, much of it by central banks themselves. Correlations across markets have been unusually high and asset price inflation has been rife almost everywhere.

In this liquidity-fuelled bull market, determining which investors have been generating genuine alpha and which have merely been riding the beta wave is tricky. However, it is clear that many have benefited significantly from the strong return environment given the high correlation of their returns with the underlying market betas. Investors now face a number of bumps in the road that will require them to devote much more attention to the direction of travel:

  1. QE becomes QT. Arguably the most important change is that quantitative easing is gradually being replaced by “quantitative tightening” (QT).
  2. Volatility gets more volatile. The VIX rose close to 40 in February (on a daily-priced basis), nearly half way to the peak level hit during the depths of the global crisis in 2008. Markets seem have woken from their recent slumber with quite a jolt.
  3. Term premia are increasing. Although they remain low, we expect rising risks to be reflected in higher term premia for bonds.
  4. Macro uncertainties are growing. Popular discontent fuelled by stagnant wages and immigration remains a potent force in battling globalisation and free trade. Bad news on these fronts could trigger an over-reaction in bond markets.

These adverse currents suggest that investors will have to navigate increased market volatility, while the withdrawal of QE will remove the “downside insurance” hitherto provided by central banks’ bond buying activities.

In these circumstances, old assumptions about managing bond portfolios may no longer hold true. A traditional sector rotation approach that switches between different fixed income asset classes may still leave investors exposed when a manager attempts to reduce their allocation to specific areas. This is because correlations between sectors often remain high.

A more fruitful approach may be to rely on macro risk rotation, which identifies major themes driving markets, such as central banks’ suppression of market volatility, the impact of the rise in populism or the potential return of inflation.

These allow the portfolio to be tilted towards the combination of alpha sources expected to offer the highest risk-adjusted return. Given the low correlation of these risk factors with each other, a blend of them tends to make the strategy less correlated with any specific asset class, helping to increase the portfolio’s diversification properties.

So, we don’t believe Goldilocks is giving way to the three bears of inflation, rates and volatility. However, it seems increasingly probable that markets will periodically fret that the world is too hot and asset prices do not fully price the risks of what may turn out to be an overheating global economy and more political noise. In these circumstances, investors would be wise to check their manager line-up is best positioned for more market turbulence.

Our full-length paper exploring the topic is available below.

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