Last year’s events brought an influx of liquidity into the market, at a staggeringly quick rate. March saw the Fed pledge unlimited bond purchases, the Bank of England announced another £200bn on top of the existing £445bn of quantitative easing, and the European Central Bank’s Pandemic Emergency Purchase programme added a further €750bn. By the end of 2020 BoE’s QE programme sat at £895bn and the ECB’s programme had grown to €1.85trn.
This support has been well received by markets, as it has been over the last decade. Bonds and equities benefitted from the low yields and financial stability afforded by this injection of money. Gilts returned 8.27% in 2020 – and that still lagged most major equity markets (the UK excluded). Not bad given the backdrop.
But as asset allocators, the question we’re trying to grapple with (amongst others) is how much financial markets will need to pay for all this support. If the answer is anything close to a mirror image of what was received, building a portfolio over the next 10 years is going to be much harder.
Before considering the implications of Central Banks actually withdrawing support, we need to consider the lesser (but more time sensitive) prospect of Central Banks just providing a bit less support. By this I mean buying less bonds. Or tapering.
A tempered tantrum?
The 2013 market reaction, dubbed the ‘taper tantrum’, was sharp. This time the Fed have tried to provide as much guidance as possible, hoping to minimise any market surprises. Comparing 2013 with 2021 suggests some relative success this year, albeit with a fairly steep incline in yield through September.
But there are many forces at work. From inflation and the ongoing debate around how long transitory is, to virus variants and future lockdown prospects, many factors feed into yield numbers. Generally speaking, uncertainty and risk pushes money into ‘safe haven’ assets such as Treasuries and Gilts, keeping a lid on yields.
As we move through the business cycle, yields should rise to reflect increasing growth expectations – a sign of an improving economy. But a tapering programme adds a lot of uncertainty around both the speed and final destination for where yields might settle. Add the current inflation conundrum and it’s even more complicated. However, it’s clear there are various forces that could push yields up. And with not a huge amount of room or rationale for them to go much lower.
Bond investors beware
2021 has given some warning strikes to bond holders. Q1 saw the UK 10-year Gilt yield move from roughly 0.2% to 0.9%, and investors suffer losses of 7.24%[1]. Following the painful September I touched on earlier, this low sits at around 8% year to date.
When we look at performance through 2013 – a year where absolute yield levels rose by more – we actually see better relative performance (around a 4% loss, roughly half that of 2021 year to date). Separating out price return from total return helps show a big reason why. 2013 investors had a higher starting yield, meaning income was a bigger part of their total return. For current investors, this isn’t a luxury they have and so the pain has been more pronounced. And there will be more upward pain before they have that luxury again. The best hope is probably for a slow and steady rise, and inflation not taking too long to subside.
All of this makes us pretty uncomfortable and has fuelled an underweight Gilt position in our Tactical portfolios for some time. There’s undoubtedly some merit in holding Gilts as an offset to equity markets. I don’t think they’ve lost their value as a defensive hedge, it’s just that they’re likely to cost rather than provide performance while doing so.
[1] FTSE Actuaries UK Conventional Gilts All Stocks.
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