Equity Bubble: Why it Makes Sense to be Wary of Duration Within Your Fixed Income Allocation?
Almost one and half years have gone by since COVID-19 first hit, and markets have gone along in a merry way. Central banks around the world have managed to keep asset prices buoyant through exorbitant quantitative easing (QE) strategies. US Federal Reserve chairman Jerome Powell recently reassured global markets that although tapering is on the precipice, interest rate rises are still some way off. Global markets enjoyed the dovish tone from the US Federal Reserve chairman with equities rallying. However, bonds rallied (yields fell) as well, which begs the question of whether bond markets have correctly priced in or are understating tapering risk? Finally, the events in the Middle East are a good reminder that geopolitical risk can poke its head out when you least expect it.
The aggregated balance sheets of the US Federal Reserve, European Central Bank, and the Bank of Japan have now increased from around USD2trn in 2000 to over USD25trn. A huge twelve and a half times increase over a twenty-year period. Low interest rates globally have encouraged aggressive risk taking to achieve above-average returns — including the use of leverage or derivative-based strategies.
Many institutional managers will have allowed risk management standards to slip to achieve set alpha targets. It is arguable if any institutional managers have really generated alpha, or it is a direct result of the liquidity injection from central banks which has helped all managers respectively. In previous cycles, this hasn’t boded well for risk assets, and we could be about to see this play out again.
One problem has been that central banks around the world have been overly accommodative as opposed to overly restrictive in their interest rate and monetary policy stance. As a result, investors have latched onto this dynamic like bees to a honeypot — and benefitted from the liquidity pumped into the global system. However, this liquidity has caused correlations and volatility (risk) relationships between the equity and bond markets to breakdown. With equity markets around the world at all-time highs and aggressive risk-taking occurring simultaneously, it is hard to not get cautious about risk assets once again.
A key risk that has also poked its head out is geopolitical risk. The current instability in the Middle East should be a concern for investors with the Delta-variant situation in the United States and generally weaker September/October period for markets. The lack of market volatility following the exit of US troops from Afghanistan also suggests markets have priced in zero downside here.
In our view, while many investors are worried about inflation being higher for longer, we believe the US Federal Reserve narrative around tapering has the potential to disrupt global markets in the near term. The famous taper tantrum in 2013 — when the US Federal Reserve threatened to remove stimulus and caused equities and bonds to both sell off (yields rose) — lives long in the memories of many investors. In fact, the positive approach by the market in response to chairman Powell’s recent speech seems to suggest many investors want to believe the story that interest rate rises are still some way off and that inflation will only be temporarily higher. Again, this will not bode well for risk markets if the playbook runs a different course.
In our view, the dwindling benefit investors have received through global liquidity being pumped into the system as well as the inflation story potentially becoming a higher-for-longer paradigm present a new dynamic. For these reasons, there is valid risk interest rate rise expectations are not being correctly priced or understated by the market.
We would be looking to hedge out duration exposure by increasing portfolio allocation to floating rate exposure, especially bank hybrids and corporate floaters. It would be advisable to increase portfolio allocations to inflation-linked bonds, where the coupon is linked to inflation. Finally, moving down the curve to shorter duration fixed rate bonds and increasing credit risk to offset the reduction in yield make sense.
Be mindful, we are not advising investors to completely sell all their fixed rate bonds. However, turning the clock back almost one and half years, we saw, at the time, that those with cash on the sidelines were able to jump at attractive opportunities once they arose. The experience of early 2020 showed us that it was useful to have some ammunition left in the tank. Selling some fixed rate bonds which are trading above par and keeping them in shorter duration fixed rate bonds could prove a fruitful strategy.
About Matthew Macreadie
Matthew’s current responsibilities include providing credit commentary/views on the bond market and specific issuers, with the aim of aiding investors to make better risk-return decisions.
Prior to joining Income Asset Management, Matthew spent eight years working as a Credit Portfolio Manager at Aberdeen Standard, where he was responsible for the credit portfolio construction and security selection across a wide range of financial and non-financial sectors.
Matthew began his career at KPMG working in Auditing and Assurance within the consumer and industrials group. Matthew holds a Masters of Applied Finance from Macquarie University and a Bachelor of Commerce from UNSW.