More of the same—when the same entails the muddling through of the global economy—offers neither many opportunities, nor much comfort to investors. World real GDP growth has settled into a 3% glide path, abetted by additional nudges from a few major central banks and several months of the absence of bad news. Led by cautious, downright change-averse US Federal Reserve (Fed) officials, US monetary policy will overstay its hand, putting inflation on a trajectory to overshoot the national goal of 2% next year. More tightening than is currently priced in will follow, but rate renormalization will remain glacial by historical standards.
The torrent of funds flowing through the sluice gates of investing opened by G3 central banks continues toward any positive-coupon instrument. This technical lift to fixed income prices should last until, well, it stops. And we have reasons to fret about its durability. We felt the fickleness of the process, and the consequences for bond yields, when doubts materialized about the willingness and ability of the European Central Bank (ECB) and the Bank of Japan (BOJ) to engineer incremental accommodation.
When so much rests on continuing confidence in central banks—and with important elections filling the calendars of major economies—the Standish advice is to:
- Keep risk budgets lean:
Valuations of fixed income instruments are mostly rich and fragile to disappointment. The cash will come in handy when prices pull back on bouts of wonderment about whether the central bankers behind the curtain have more levers to pull.
- Remain overweight breakeven inflation:
The Fed, the central bank with policy traction, wants to and will engineer a modest pickup in inflation. Indeed, expectations about inflation may not be as well anchored if the Fed does not communicate calmly once it gets what was wished.
- Keep durations at, or leaning short of, benchmarks:
Cash provides comfort, especially when yield curves in major advanced economies steepen. We would have more conviction about being short duration were it not for the overwhelming and persistent support of technical factors in pulling yields down. Central banks cannot crush volatility forever, but they have been able to do it for a very long time.
- Push even harder on security selection:
Our sense is that firms with an investment-grade rating have taken too much advantage of the tailwinds of easy finance, positioning them later in the credit cycle compared to the high-yield sector and emerging-market sovereigns. Rotation toward the better end of those two assets classes picks up some carry and can help in shortening duration. Higher quality asset-backed securities also help on both scores, as long as volatility remains relatively muted.
Download PDF for full article