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After the rapid rise in the cost of capital the world over, economies are beginning to falter. China, Germany, Holland, New Zealand and now Australia, are rapidly slowing, bringing high quality fixed income back on the radar of many serious investment committees. With many other asset classes still enjoying lofty valuations after an extraordinary period for investors, the reset of global yields in fixed income bond markets continues to draw in fresh capital, as asset allocation from large institutional investors continues to rebuild exposures to lock in future incomes and benefit from any further economic deterioration expected under restrictive policy settings.
The material reset of yields through the rate hiking cycle has delivered some markets back to yield levels not seen since the Global Financial Crisis (GFC), with many US government bonds now yielding more than 5.00%. This reestablishment of yield makes for a compelling income alternative, whilst also providing a significant cushion against further rate rises. Depending on the maturity of a bond (longer-dated bonds are more interest rate sensitive), the expected payout from equally weighted market moves remains very attractive. Consider an investor who purchased a short-dated US Treasury 2-year bond at 5.00%. If yields increased to 6.00% over the following year, the total return after one year would still be around 3.20%. However, if yields dropped to 4.00%, the total return on the bond would rise to about 6.90%.
While higher yields are undoubtedly attractive as a standalone investment, the asset quality and liquidity of government bonds also offer portfolio optionality for dynamic asset allocators. Using the experience of the pandemic of 2020 as an example, high quality fixed income assets performed extremely well, rallying strongly while many other asset classes suffered under intense uncertainty. Australian equities, for instance, experienced a nearly 40% pullback at one point. During this period, investors capitalised on their fixed income holdings by selling at a profit and strategically transitioning into undervalued equities, reaping substantial profits. This exemplifies precisely how a defensive strategy is intended to work.
As we approach football finals around the country, it is worth considering which position your own assets might play on your investment team? Strong policy support and a booming economy have had many portfolios set up to be kicking with the policy wind, running with plenty of risk looking to keep the scoreboard humming. As those global winds (and policies) have turned, the backline of defense requires more consideration, as not all defence is created equal. A thorough assessment of ‘fit for purpose’ is also required to engineer solid outcomes, should harder times arrive for asset markets into 2024.
It’s valuable to understand the difference between hybrids, high yield bonds (often referred to as junk bonds), corporate bonds, and government bonds. It's also important to weigh the availability of capital in public markets against the distinct characteristics of private markets, where investment horizons and lock-up periods can be considerably more extended. Additionally, ensure that asset offerings pass the sniff test. If public markets have had huge pullbacks over 2022, shouldn’t that impact private markets also? What can we anticipate for private market assets that have yet to reset moving forward?
We believe that, from a medium to long-term cyclical perspective, the risk/reward ratio for high quality government bonds as an asset class is becoming highly attractive for inclusion in a balanced portfolio. The return outlook for Treasuries in the coming year, with yields at approximately 4.25%, strongly favours buyers. A potential market rally offers greater rewards from the capital appreciation and the coupon reinvestment, whilst a further rise in yields would be somewhat mitigated from coupons received.
With Central Banks at the end of their tightening cycles and the specter of the global growth slowdown lurking ominously, many leading indicators such as inverted yield curves, tightening bank lending standards, slowing of mortgage applications, and weakening labour markets have historically been prescient indicators of a recession. Economic ills in China and Germany, historically countries that navigate through economic growth slowdowns, would suggest that the recent velocity of monetary tightening is impacting manufacturing and exports and the broader global economy.
The Antipodean Central Banks, the RBA and RBNZ, have strongly hinted that they are both at the end of their respective hiking cycles. This serves as an important indicator and has implications for other global Central Banks. It's particularly noteworthy given that these economies are heavily leveraged and vulnerable to the potential impact of global economic growth downturns. New Zealand is already in official recession, albeit mild but with no policy support forthcoming, we expect this will continue to broaden to a more severe slowdown. Australia is now in a ‘per capita’ recession, as GDP per person was -0.3% in both the March and June quarters, meaning it is only population growth that is keeping the nominal numbers above zero. Historically the probability is high that rate hikes presage floundering economies and given the velocity of this rate hike cycle, the chances of a hard landing should supersede chances of a unicorn soft landing.
The benefits of including high quality fixed income in a portfolio is compelling, particularly as the bond market traditionally rallies after the last rate hike. This becomes even more significant in the context of the current business cycle, which exhibits a distinct divergence in performance. While a defender might not typically win a Brownlow or a Dally M, their role is critical in bringing home the silverware late in the season or investment cycle.