While it’s natural to focus on performance in periods of economic uncertainty, for long term investors there are broader considerations, for example duration, worth taking into account.
Duration - the measure of how sensitive a bond’s value is to interest rate changes - is a crucial element to consider. Bonds provide income and ballast against the downside in periods of weaker than expected growth, a sudden financial crisis or an escalation of geopolitical risk.
All of these remain distinct possibilities right now which is why, despite their struggles in comparison to equities this year, we believe bonds play an important role in a diversified portfolio.
Equity and fixed returns 29th December 2023 - 14th June 2024
Source: FE fundinfo 2024
The benefits of diversification
The ups and downs of markets are a challenge for investors. But they’re also an opportunity. As expectations for growth, inflation, interest rates and earnings change, so do relative returns across different asset classes. This creates a range of returns that is notoriously difficult to predict. Nothing demonstrates this better than the image below.
Global asset return matrix (monthly USD returns)*
Source: Oxford Economics
So, for long term investors, the best way to navigate unpredictability is with a diversified portfolio. One made up of a blend of defensive and growth assets. Over time this can help to smooth returns, support compounding and leading to attractive client outcomes.
Global government bond volatility
Volatility in global government bonds has been high since central banks started raising interest rates in the first quarter of 2022. As disinflation slowly comes through and prospects for interest rate cuts grow, this volatility is expected to narrow. With relatively attractive starting yields of over 4%, the security of income they can provide within a diversified portfolio is growing in appeal.
If we see interest rate cuts of over 1% over the next 18 months (as projected in the Fed’s latest dot plots) there could be scope for equity, like double digit returns but with markedly lower volatility. Those characteristics associated with longer duration global government bonds would bring welcome news for low and middle risk grade investors.
Debt, deficits and depreciation
One potential snag in this promising outlook is the well documented and growing mountain of global government debt.
The US debt ceiling, which has been suspended until 1st January 2025, is expected to resurface as a point of investor focus. With the US debt to GDP ratio more than 124% as at March 2024 and the government fiscal deficit 6.3% in 2023, there are legitimate concerns that anything other than a ‘soft landing’ will lead to increased debt. This would place upward pressure on bond yields as longer term bond holders demand higher compensation.
History shows that in periods of economic slowdown, investors seek the relative safety and refuge of government bonds. The absolute level and security of income helps to underpin their uncorrelated returns.
Where things may be different this time is that having come through a period of weak growth, countries outside the US are beginning to show signs of economic improvement. As a result, the US dollar looks more vulnerable to weakness, albeit from a strong starting point.
With on-going geopolitical risk and the US dollar being the world’s reserve currency, we don’t anticipate meaningful depreciation. However, a plateauing from recent strength appears probable. This would support non-US asset classes, including the non-US government bonds held within our global government bond asset class.
Duration is a friend not foe
Within our strategic asset allocation, global government bonds are a core building block because of their proven differentiated risk adjusted returns. We know that the diversification benefits for investors have been absent for a while. But we believe that foregoing some short term returns for greater consistency of risk adjusted returns is an appropriate and rewarding strategy for investors over the long term.
With interest rates past their peak, the benefits of attractive starting yields plus duration makes them an important component within our diversified portfolios.
This article is for financial professionals only. Any information contained within is of a general nature and should not be construed as a form of personal recommendation or financial advice. Nor is the information to be considered an offer or solicitation to deal in any financial instrument or to engage in any investment service or activity. Parmenion accepts no duty of care or liability for loss arising from any person acting, or refraining from acting, as a result of any information contained within this article. All investment carries risk. The value of investments, and the income from them, can go down as well as up and investors may get back less than they put in. Past performance is not a reliable indicator of future returns.
