The economic background: inflation is falling following central-bank policy U-turn

Inflation is the main economic problem confronting policymakers, and they’re intent on eradicating it. That’s good news for bond investors, since inflation erodes the appeal of the fixed income generated by these instruments. In fact, inflation is often described as the main enemy of investors in the asset class. Yet while central banks have aggressively raised interest rates over the past two years or so, they’re unlikely to concede that the ultra-loose monetary policies they instigated following the outbreak of the Covid-19 pandemic triggered the current bout of inflation.

Our view is that inflation is a monetary phenomenon: a spike in the money supply will be followed by a rise in inflation about 18 months later. There’s plenty of evidence to support this contention. Quite simply, countries that don’t print money tend to have low inflation. For example, inflation in the developing world is currently much lower than in the advanced economies. The latter printed lots of money to support economic activity during the pandemic lockdowns, while the emerging world – lacking the same level of resources – didn’t take that course of action.

But while too much money chasing too few goods caused the recent jump in inflation, supply chains – previously disrupted by lockdowns – are now normalising. It’s even possible that we’re entering a period of too little money chasing too many goods – in other words, deflation – with inflation returning to central-bank target levels. The range of possible outcomes on inflation underlines just why we believe that investors need exposure to a diversified range of income-generating assets.

The implications for bond investors

Bonds are once again offering attractive value and are likely to become even more appealing as inflation declines. US Treasury yields, currently yielding around 5%*, are unlikely to go significantly higher – and if inflation drops to 2%, real yields will stand at 3%. In our view, at current valuations, bonds offer far more upside potential than downside risk.

The fact that valuations are far more attractive today than just a few years back means that it also makes sense to focus on bonds with high duration, i.e., those that are particularly sensitive to changes in interest rates. These bonds should deliver strong capital gains if, as we anticipate, US interest rates start to fall next year as economic activity slows.

* Source: Bloomberg, 30 October  2023.

Corporate bonds

It always makes sense to invest in instruments with an excessive risk premium, as opposed to those with no or negative risk premiums. Currently, investment-grade and high-yield bonds offer significant potential given the high risk premia on offer. Consequently, investors are being compensated for a very large degree of risk, a situation that hasn’t existed for the past 10 years or so. Credit is thus a far more interesting asset class to investors than it was just a few years back.

Why it makes sense to own equities in a bond fund

Owning equities in a bond fund might not appear to make sense. But high-yield bonds are highly correlated with equities and don’t behave like government bonds. So, when equities are cheaper than high-yield bonds, it makes sense to own equities – and vice versa. Moreover, high yield bond provide exposure to duration and credit risk.

It’s also important to remember that every asset – whether it be property, equities or bonds – could simply be an expected income stream, so it makes sense to own any of these assets when their valuations are attractive. Pragmatism and flexibility – rather than a dogmatic focus on bonds - are the key to maximizing income.

Asset allocation changes as the economic backdrop alters

A flexible asset allocation approach allows investors to vary their exposure to particular sectors according to the economic background. There are essentially four economic scenarios. In an era of deflation, such as Japan experienced in the 1990s, a portfolio should have significant exposure to duration and avoid credit risk given likely high default ratios. So, the focus would be on high-quality, long-dated bonds. Conversely, in periods such as during the outbreak of the Covid-19 pandemic, it would be wise to take on credit risk and avoid duration, given that interest rates are tumbling and expectations for defaults are excessive.

An example of the third economic scenario can be found during periods of stagflation, when inflation is high and growth is low. Given the likelihood of corporate defaults and the fact that inflation is eating into the buying power of income, the best option is to focus on assets that don’t generate an income but rather can hedge against inflation. Examples include gold, undeveloped land and art.

The final and best scenario of all is when economic growth is healthy, inflation is falling and there are few, if any, defaults. Examples are rare but include the 1990s bull market in European equities. During these periods, investors should target equities, which will benefit from strong economic growth and falling inflation.

Why a flexible approach makes sense

Simply tracking the index, which means taking a high degree of exposure to government bonds, with a relatively small amount of a portfolio devoted to the investment-grade and high-yield sectors makes little sense given the constantly changing nature of financial markets. The ability to respond instantly to geopolitical and economic news calls for a far more pragmatic approach. That could involve focusing on government bonds and duration (the sensitivity of bonds to movements in interest rates), and avoiding credit markets: when risk appetite is low. This could be during periods of high economic uncertainty, for example. By contrast, when the economic background is positive and risk appetite is high, seeking exposure to credit markets and avoid duration is likely to prove the most rewarding strategy. Meanwhile, adding exposure to equities to an income portfolio provides the managers with an additional asset, with relatively low correlation overall with fixed income, that can potentially generate extra returns above those possible from the fixed income sector.