Investor Insight, May 2022

Since the devastating war in the Ukraine commenced, equity markets (except for those in Europe) have been on a strong run, and even those that were bearish at the beginning of this calendar year were seeing equities test new highs in some cases.

At the same time bond markets have been selling off, market interest rates going up in anticipation of Central Banks increasing official cash rates.

To put this into perspective, ten-year US Treasury Bonds ended 2021 at 1.40 per cent and ten-year Australian Treasury Bonds ended 2021 at 1.60 per cent.

Ten-year US Treasury Bonds are ending April 2022 at around 2.95 per cent and ten-year Australian Treasury Bonds are ending April 2022 at around 3.10 per cent.

This has been the biggest sell off in bonds on record, dating back to 1973, and Bloomberg long-term US government bond indices are down approximately 18 per cent this year.

This is the reason we do not have duration in portfolios. In managing risk in our client portfolios, we made a decision some time ago not to have any domestic or global bond duration within these portfolios due to the strong likelihood of sustaining losses.

Whilst bond markets have been selling off, equity markets shrugged off these concerns and it was as though they were simply waiting for the inevitable, being further central bank rate increases.

We haven’t mentioned it for a while but the TINA effect or “There is No Alternative” positively affected equities as global stock market indices benefited markedly from fixed income outflows.

The selloff in equities earlier this calendar year also provided more generous valuations and those previously high valuations now look considerably less pronounced.

This was the case until two weeks ago when the selloff in bonds finally caught up with equity markets and equities resumed their selloff also.

So where are we?

The clear messaging from the Federal Reserve (the Fed) is that it will take the “necessary steps” to get inflation under control. Seven more rate hikes for the US are currently being priced in for 2022. There can be no doubt, the Fed’s priority is to fight inflation at any cost.

The continued sell-off in bonds reflects further upward revisions to market participants’ expectations for future policy rates. With inflation still high and central bankers turning ever more hawkish (propensity to increase rates), Capital Economics in London has revised up their forecasts for near-term rate hikes for most major Developed Market central banks.

They now forecast the 10-year Treasury yield in the US to reach 3.25 per cent by the end of this year, up from its current level of approximately 2.95 per cent, against their previous forecast of 2.5 per cent.

Capital Economics thinks long-term yields will generally peak over the next twelve months or so, with the 10-year US Treasury yield reaching 3.75%. The experience of previous tightening cycles is that the peak in long-term yields has typically occurred a few months before the last rate hike. Based on their revised interest rate profiles, they think the peaks in long-term yields will be in mid-to-late 2023 in the US, the UK, and the euro-zone. But in Canada and New Zealand, for example, the peaks could come earlier – perhaps later this year– given how much further along these central banks are in their respective hiking cycles.

This view is also supported by our asset allocation consultants Heuristic Investment Systems who believe fixed income markets have factored in “aggressive tightening” with policy settings “at neutral by year-end” and rising to 75 basis points or 0.75 per cent above neutral by mid-2023.

After they reach their peaks, Capital Economics thinks long-term yields will begin to fall in many places. Just as the hikes look set to be accelerated, they think the transition to easing cycles in many economies will be accelerated also, either because central banks have brought rates above neutral to stamp out inflation and will have to bring them back down (such as in the US), or because troubles in housing markets will start to weigh on some countries’ economies (such as Canada, Australia and New Zealand). As a result, they expect yields to be lower by end-2024

The good news is that GDP growth for now still looks solid, particularly given the health of the US jobs market (rising wages and participation rates). However, it is hard to ignore the fact that higher inflation will eat into consumer disposable incomes and hence could trigger a slowdown in economic activity down the track.

Heuristic believes the US economy is late cycle (this cycle has been exceptionally fast as we have mentioned previously), and at this phase of the cycle solid returns can be experienced but with volatility as “investors grapple with the timing of the expected downturn with policy above neutral”.

Our asset allocation is neutral, and we can only reiterate the importance of diversification, especially with the increased volatility that we expect to continue. We are experiencing rising interest rates and inflationary pressures that we have not seen for decades, therefore expect returns to be different from the past decade but diversification to provide a superior source of risk adjusted returns.