Central banks provided the motive force that drove the good returns in developed market equities and bonds since the Great Financial Crisis. Policies that were intended to push against the risks of deflation brought us record low bond yields, negative cash rates and asset purchases on an unprecedented scale. Most asset classes did well as a result.
But today a new force is driving market sentiment. Trends in international relations, which for the last 50 years embraced a liberal market approach of free movement of goods and capital, seem to be going into reverse. This poses a new challenge for investors. The most obvious sign is worsening US-China relations which carries the threat of trade-war, 'beggar-thy-neighbor' currency manipulation, tariffs and disruption to global supply-chains. And there are similar challenges caused by political decisions elsewhere. How these politically driven events play out will have as big a say in shaping future investment returns as central banks did in the last 10 years. But they are hard to predict, even for the most seasoned investors.
Jonathan Gregory, our head of Fixed Income UK talks about bond strategies that could work as the trade war plays out. He believes in a flexible, non-benchmark approach. This calls for buying US and China bonds and shorting expensive positions in the Eurozone.
Two main scenarios
1) The World of Yesterday
On one hand global leaders may navigate a path back from the fractured international relations of today to what already feels like 'World of Yesterday'; the world of open-markets and relatively free-trade. If so, then the worst case outcomes for global growth can be avoided. In the current climate, bond prices will probably fall, particularly in Europe, where deeply negative yields in core countries currently reflect a much more dismal outlook. But the breakdown in international relations could also accelerate, perhaps because some leaders pursue narrower populist agendas, or because they are not fully in control of events themselves.
Head of Fixed Income UK
Best and worst FI sector returns over the last 5 years
2) Down the Rabbit Hole
This would take us to a deflationary 'Down the Rabbit Hole' world of higher prices, falling investment, lower profits and higher unemployment. In this case, bond prices are heading higher and credit and equity markets face serious downside risks.
How can investors hope to protect their bond returns under these circumstances?
Our answer: flexibility and diversification in fixed income
For instance our Global Dynamic Bond strategy has no fixed benchmark but the flexibility to invest in the best opportunities in bonds globally. Therefore we avoid 'hard-wired' exposures to the sectors that could be vulnerable if we return to 'The World Of Yesterday' such as Eurozone government bonds and we diversify.
Today that means owning bonds in the US and China but with short positions in expensive regions like the Eurozone. This should support returns in either 'The World of Yesterday' or 'The Rabbit Hole World' because, in either case, we expect these regions to outperform; in other words they offer better relative value today.
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