By Niall O’Sullivan
Why we think this year’s dramatic rise in bond yields, together with recent signs that inflation may have peaked, demands a radical re-think of asset allocation?
“When the facts change,” as John Maynard Keynes may or may not have said, “I change my mind. What do you do?”
We’ve been on the road visiting clients around Europe over recent weeks, and they appear to agree with the great economist. Many think it’s time to re-think their asset allocations, because they see how much the variables around the asset allocation decision have changed.
They no longer believe their current exposures are fit for the conditions that have emerged this year, and they can sense that the dramatic rise in bond yields has been the major disruptive factor. Asset management partners are being called in to help interrogate the problem, and we are finding ourselves opening playbooks that have sat on the shelf for a decade or more.
Which asset classes tend to get included on an asset allocation menu?
In simple terms, this is a function of estimated returns and the degree of certainty around them. Where are valuations attractive, and is the risk tolerable?
This year has seen valuations decline substantially across most asset classes. And since mid-October, as investors have become more confident that inflation may be peaking, volatility has been falling, too. That feeds into the value-at-risk (VAR) models used by many investors, which may be facilitating the increase in risk taking seen in the fourth quarter this year.
These two new conditions have had a big impact on the lower-risk part of the asset allocation menu.
For example, if you have an inflation-plus return target, one of the traditional cornerstones of your asset allocation – inflation-linked bonds – has been off the menu for years because of valuations. The U.S. 10-year real yield struggled to get above 1% for a decade and was negative during 2012, 2020 and 2021. Germany’s real yield was at -2.5% as recently as March.
Now, the U.S. real yield appears to have settled in the 1.40% – 1.75% range, Germany’s real yield is back to zero and those of France and Italy are positive once more. As inflation peaks and rate market volatility eases, these newly attractive valuations are likely to push inflation-linked bonds up the asset allocation list again.
In riskier assets, the picture is more complex.
In local currency terms, equities are down around 8% in Europe and 15% in the U.S. this year, having bounced off lows of more than -20% in mid-October.
That rally in valuations has been fueled by the growing sense that inflation and interest rate expectations have peaked – but this is not necessarily good news for corporate earnings.
Because reported earnings are nominal, declining inflation generally means declining earnings, absent some other source of growth, and if inflation declines over the coming months, it will likely be because growth is declining. That’s why we are not yet convinced that equity markets have seen the bottom of this cycle – or the last of their volatility.
However, we think a peak in inflation, rates and rates volatility is likely to be more straightforwardly positive for fixed income assets – whether inflation-linked bonds, or credit.
We don’t see bond coupons facing as big a threat from slower growth as earnings, as we believe the slowdown is likely to be measured. On refinancing risk, while some companies will have to deal with higher rates next year, most corporate bonds have at least another three or four years before they mature. And credit market valuations have corrected decisively.
Even after the rally of the past few weeks, global high yield bonds yield around 9% and offer a spread of more than 500 basis points. Euro high yield was barely yielding 3% in January, but is offering more than 7% today. Opportunities are opening up in other areas of credit, such as direct lending, which is benefitting from the slowdown of the syndicated loan market.
In short, this combination of more attractive valuations, declining volatility and a position higher in the capital structure gives us one of the most important new aspects of current strategic asset allocation processes: the higher-risk sectors of the lower-risk asset classes are suddenly at the core of suggested asset allocation mixes rather than being merely a source of incremental yield.
And that word “suddenly” underlines another theme we’ve picked up with clients.
When things move as quickly as they have this year, and when the economic cross-currents are so complex, we believe it’s important to think tactically as well as strategically. That also implies mindfulness of opportunities beyond asset classes, across a broader range of risk factors.
The two market rallies since the summer are the obvious examples of this, offering opportunities to rotate between risk-on and risk-off, value and growth, cyclicals and defensives. In addition, varying duration could be a source of tactical opportunity if bond yields have indeed peaked and settled in a range, as could currency market volatility as the U.S. dollar peaks and global monetary policy re-aligns.
These are just some of the ways we’ve seen variables around the asset allocation decision change over the course of 2022. Our recent conversations suggest these new conditions are changing minds – and portfolio profiles.
In Case You Missed It
- Eurozone Purchasing Managers’ Index: +0.5 to 47.8 in November
- U.S. Durable Goods Orders: +1.0% month-over-month in October (excluding transportation, durable goods orders increased 0.5%)
- U.S. New Home Sales: +7.5% to SAAR of 632,000 units in October
- Japan Manufacturing Purchasing Managers’ Index: -2.4 to 46.3 in November
What to Watch For
- Tuesday, November 29:
- U.S. Consumer Confidence
- S&P Case-Shiller Home Prices Index
- Wednesday, November 30:
- U.S. 3Q2022 GDP (Second Preliminary)
- China Purchasing Managers’ Index
- Eurozone Consumer Price Index
- Thursday, December 1:
- U.S. Personal Income & Outlays
- ISM Manufacturing Index
- Friday, December 2:
- Tuesday, November 29:
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