Has Fake News Spread to the Bond Markets?
by Erin Bigley, Senior Portfolio Manager—Fixed Income, AllianceBernstein
Fake news. It’s pervasive these days. And it’s no longer exclusively a problem for politicians, journalists and Facebook. It’s made its way into the capital markets too, particularly in areas of major global economic and financial impact.
When the bond markets are clouded by questionable information, it’s that much more challenging for investors to make prudent decisions about risk, income and return.
We’ve sorted through the fake news and analyzed the facts. Here are our takes on the top three misleading characterizations that investors have been asking us about.
Inflation Is Dead. #FakeNews
It’s true that over the past decade, inflation has been remarkably dormant. But investors should look out for rising prices ahead.
Several forces are likely to push prices higher. The first is populism. Populism can exert upward price pressure in three ways: by “raising a drawbridge” that effectively tightens countries’ borders—restricting trade flows, capital and labor; through institutional erosion, such as joining monetary policies to fiscal policies; and through redistribution.
The second inflationary pressure comes from demographic trends. We analyzed more than 150 years of data from the UK showing that, as the working-age population declines, inflation increases. With baby boomers now retiring, a smaller supply of workers and a larger share of retiree consumers should translate into higher prices.
High debt burdens are a third inflationary pressure. A useful way to reduce a large debt burden is to inflate it away. Accordingly, governments may favor inflationary policies. (This tends not to go over well with older voters, however, who resist inflationary policies because they erode the purchasing power of their fixed incomes.)
A counterweight to the above inflationary forces is technological innovation, which drives down prices. We’ve observed this phenomenon for centuries, with the invention of the cotton gin, the emergence of railroads, and more recently innovations in the personal computer and the corresponding decline in computer prices.
However, technology won’t be enough to offset populism, demographics, debt burdens and, critically, the improving employment and GDP picture, which together point to rising prices over the next few years.
The Era of QE Is Over. #FakeNews
The improving economic environment and the first balance-sheet sales by the Federal Reserve have pundits announcing the end of QE. But QE and its tremendous impact on bond market yields isn’t in the rearview mirror yet.
It will take time for the Fed to unwind its massive balance sheet. And the European Central Bank (ECB) has only just begun to taper its purchases. Meanwhile, the Bank of Japan (BOJ) continues to add to its overall stock of bonds.
That means the global effect of QE is very likely to persist for a couple more years. In fact, 2018 will still show a total net purchase of US$430 billion of bonds worldwide, and it won’t be until 2019 that we expect to see a net reduction in the size of global central bank balance sheets.
We quantified how much global QE has depressed global interest rates, breaking down the impact of various factors into expectations for future official rates; uncertainty, or implied volatility; demand; and supply. This allowed us to forecast the impact of various central banks’ policies on global interest rates.
The results? We project that even as the US Fed’s impact on rates shifts from downward to upward pressure, other central banks’ actions will continue to depress interest rates—not only their own, but US rates and Canadian rates and so on. If the ECB and BOJ continue their purchases as we expect, we’ll continue to experience downward pressure on US and global bond yields.
Furthermore, as the Fed reverses QE and global markets experience competing pressures from the major central banks, volatility is likely to reemerge.
When US Rates Rise, Emerging Markets Suffer. #FakeNews
In reality, the global growth backdrop is much more important for emerging markets (EM) than are Fed policy and rising US interest rates.
We looked into the returns of both hard-currency and local-currency emerging-market debt (EMD) during periods of rising US Treasury yields.
We found only three sell-offs in nine periods of rising US rates: in 1994, 2013 and 2016. The latter two corresponded to the “taper tantrum” and the US presidential election, respectively. EMD enjoyed positive returns in the remaining six periods.
Of particular relevance today is the Fed hiking cycle of the mid-2000s. That cycle most closely approximates the one we are experiencing today and will continue to see unfold in the coming years: slow and steady hiking in an environment of solid global growth. Those conditions proved to be strongly positive for both hard and local-currency EMD returns.
Real Investing in the Era of Fake News
Here are some strategies we recommend for navigating today’s environment:
1. Add inflation protection to your portfolio. There are many varieties of protection available for different types of portfolios, from Treasury inflation-protected securities to Canadian real-return bonds to Japanese linkers to inflation strategies for US municipal investors. Many markets are underpricing our longer-term expectations for higher inflation.
2. Consider a barbell strategy. Many investors look at today’s strong growth backdrop and the gradual normalization of monetary policy and conclude that credit assets are their best bet today. But it’s not that simple.
Thanks to QE, asset prices have already had a big run-up in value. For US and European high-yield bonds, credit spreads are hovering near record lows. There are still opportunities in credit markets, including high yield, EM and securitized mortgage assets. But in our view, given current prices and conditions, investors should think twice about taking on too much credit risk.
We believe a better approach pairs interest rate–sensitive government bonds with growth-sensitive credit assets in a single strategy known as a credit barbell. Because the returns from the two types of assets are negatively correlated, strong returns on one side of the barbell can outweigh weakness on the other.
A barbell strategy continually balances and adjusts interest-rate risk and credit risk, altering portfolio weightings as valuations and conditions change. Even as rates rise, a barbell strategy includes government bonds, which provide important diversification to credit exposure.
US Treasuries and German Bunds might struggle over the short term if tighter policy eventually causes the yield curve to steepen. But even in rising-rate environments, these assets provide crucial stability, diversification and income: over the medium term, more than 90% of US Treasury returns come from the yield. This means that rising rates can dramatically boost income for investors who are not primarily focused on short-term price fluctuations.
What’s more, higher rates will eventually slow growth and put an end to the credit cycle. When this happens, managers can rebalance portfolios by selling highly liquid government bonds and buying more credit assets at discount prices.
3. Diversify your high-income portfolio, and be selective. When yields are low, valuations are high, and volatility is on the rise, it’s more important than ever to exercise caution. Investors should resist the urge to reach for yield and instead concentrate on maximizing opportunity across many sectors and regions, and on reducing risk. A global, multi-sector strategy can provide access to multiple sources of income and return.
4. Allocate to emerging-market debt. EM bonds delivered strong returns last year. We think the sector has more potential, thanks to improving economic fundamentals, stable or falling inflation in EM countries, and critical reforms that have reduced individual countries’ vulnerability to external shocks.
With global economic and geopolitical risks rising, however, investors will have to exercise caution. Fortunately, political risk tends to be country specific. This means investors can limit the volatility that any single country’s political risks might generate by being selective and by diversifying across EM countries.
Just the Facts
So what’s real? The reemergence of volatility, given competing central bank policies and the unwinding of the Fed’s balance sheet. Inflation risk. And a positive environment for emerging markets. What are also real are approaches for managing these risks and opportunities.
By digging deep into research, managers and investors alike can counter the spread of disinformation and uninformed opinions. Because in the world of investments, facts still matter.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.
Copyright © AllianceBernstein
