Market Solutions – October: Global Bond Weakness Gathers Steam In September 2018

By Alexander Forbes Investments on Oct 10, 2018 in Market and Economic Commentary

At Alexander Forbes Investments we maintain that the forthcoming financial market cycle won’t look the same as the past cycle where traditional bond and equity asset class returns were abundant. Portfolios must be positioned differently to protect against a change environment. The United States (US) 10-year bond yield weakened above 3.2% in early September 2018, its highest level since April 2018, which provides further confirmation of this shifting trend. Developed market (DM) bond yields had been in a declining trend since the 1980s, supported by aging populations, declining economic growth, soft inflation, growing debt and the low interest rate policies of major central banks. Since 1980, amid this trend, the US Treasury index has returned 7.1% in nominal annual returns in USD and 3.1% in real terms – the types of returns we would love to bank on today, if we could.

Since late 2016, developed market yields have been rising due to a combination of tighter US Federal Reserve monetary policy and rising inflation. In the past year the US Treasury index lost 1.7% in nominal USD and 3.8% in real US CPI-adjusted terms. The World Government Bond Index (WGBI) lost similar ground. Current and expected rates of nominal gross domestic product (GDP) in developed markets suggest still higher yields could be in store. Higher bond yields are associated with weaker bond performance. Lower allocation to developed market bonds is one of the risk-mitigating measures in place within our major accumulation portfolios to cushion the effects of the changing environment in global markets and assist clients on their journey towards retirement.

Looking ahead, the risk to the weakening trend in global bonds is a sudden reduction in global growth and inflation, which could see investors rush back towards the safety of these bonds and result in stronger performance than expected. The flattening of the US yield curve, which is historically a great predictor of US recessions, confirms the importance of monitoring this risk. However, for now, growth and inflation continues to support the trend higher in yields. Yields in Japan and Europe are particularly low relative to the rates of nominal growth in those regions. The European Central Bank’s (ECB’s) shift towards less supportive monetary policy, which implies fewer purchases of European sovereign debt, creates another headwind for bond markets in that region.

Higher yields across major global bond markets is an important development for financial markets and has ramifications over and above the performance of global bonds. Developed market bond yields are the standard yard-stick off which other investments are priced. Higher yields in these bond markets cause investors to ask more difficult questions about other holdings within their portfolios. For example, does an investor want to hold Italian 10-year bonds, which are yielding 3.6%, when the equivalent 10-year US bond is yielding 3.2%? This question is particularly important when one considers that the current Italian government is trying to break European Union budget rules and implement a wider budget deficit. A wider deficit implies greater future debt accumulation, adding to Italy’s already large debt-to-GDP ratio of 131%. This hypothetical question can be asked about numerous assets around the globe. This is why we talk about a period of risk re-pricing as the global economic and policy environment transitions, and investors reassess the risk-return profile of the assets within their portfolio.

South African bonds present another example where risk re-pricing takes place. Investors question whether the spread between SA bond yields and US bond yields is adequate to compensate for the risk of lending to the government. Fortunately for South Africa this spread is reasonably elevated at this stage. The spread between the South African benchmark 10-year bond and the US was trading above 6% in early September. This spread was higher during the 2016 domestic market volatility but current levels aren’t far off the long-term average for this spread of 6.4% and it’s currently higher than the post 2008 average of 5.8%, which indicates that the pressure for SA bond yields to increase is perhaps not quite as strong as some other global bond markets.

Risk re-pricing during this transition creates financial market volatility as investors question whether previous relationships will hold in the same way in the future. The addition of hedge funds into major accumulation portfolios allows investors to benefit from this volatility, while private equity serves as a less volatile asset class that can also bolster returns during this leaner and more volatile return environment.

Alexander Forbes Investments

Alexander Forbes Investments

Alexander Forbes Investments was established in 1997. We are a forward-thinking and trusted global investment provider, with roots in Africa. In pursuit of certainty we set out to understand our retail and institutional clients’ circumstances and risk tolerance to set clear goals. Our adaptive investment approach, called Living*Investing allows us to maximise opportunity and minimise risk at every stage of the investment cycle.

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