Adapting to a new regime

15 Jan 2019

After years of central bank influence, bond markets are now pricing in the unwinding of QE. This should reverse low levels of term premia and real yields. With core bond markets changing structurally, are bonds still useful for hedging?

2018 left investors with almost no place to hide as most major asset classes posted negative returns (see Exhibit 1 below).

 

Exhibit 1: A difficult final quarter for equities in 2018

a-difficult-final-quarter-for-equities-in-2018

Source: Bloomberg and BNPP AM, as of 09/01/2019

 

Strikingly, given the equity market losses, bonds also fell, driving yields higher on the year, even when taking into account the sharp safe-haven led drop in yields in the last weeks of the year. In fact, a traditional 60:40 portfolio of US stocks and bonds lost slightly more than 1% in 2018, marking the first negative return since 2008. And considering an annual average return for 60:40 portfolios of nearly 9% since the 1980s, the changing market dynamics are becoming apparent.

Dissecting fixed-income price action produces interesting results (Exhibit 2). Most of 2018 saw higher nominal yields driven by rising real yields and inflation break-evens moving sideways. And even the sharp rally in bonds in the closing weeks of the year was driven by a collapse in inflation break-evens, with real yields still near their highs.

 

Exhibit 2: US fixed income: real rates up, break-evens (recently) down

us-fixed-income-real-rates-up-break-evens-down

Source: Bloomberg and BNPP AM, as of 09/01/2019

 

After years of central bank influence, fixed-income markets are now pricing in the unwinding of quantitative easing (QE). This should reverse depressed levels of term premia and real yields.

 

The role of bonds as a means of hedging equity exposure is being brought into question

With core bond markets undergoing a structural change, their role as portfolio hedging instruments is being questioned. Indeed, we have been underweight fixed income as part of our core positioning for some time and are expressing our portfolio hedges via different assets instead.

One such hedge is a short in high-yield credit, which is performing much better than safe-haven bonds, selling off together with – and arguably even ahead of – equities (Exhibit 3). We continue to think that high-yield credit is vulnerable at this stage of the cycle. Historically, spreads are tight and as an asset class, credit is vulnerable to quantitative tightening and slower growth.

 

Exhibit 3: High-yield credit a better risk hedge

high-yield-credit-a-better-risk-hedge

Source: Bloomberg and BNPP AM, as of 09/01/2019

 

Central bank tightening fuelling volatility

One of the key themes from our 2019 multi-asset outlook is summarised well by Exhibit 4 – we expect more volatility.

Since the great financial crisis, the aggressive and unconventional monetary policies of the main central banks have been a major support for equities and other risky assets. These policies led to unusual market distortions such as persistently low asset price volatility, high risk-adjusted returns and historically tight risk premia in both equity and fixed-income markets.

It is these imbalances which look set to unwind as central banks trim their balance sheets and raise interest rates, in other words, as ‘quantitative tightening’ gathers momentum.

 

Exhibit 4: Expect more volatility as the Fed tightens monetary policy

expect-more-volatility-as-the-fed-tightens-monetary-policy

Federal Reserve policy stance calculated as the spread between the real fed funds rates and R* estimates. Source: Bloomberg and BNPP AM. Data as of 09/01/2019

 

The market’s response to December’s policy-setting meeting of the Federal Open Markets Committee (FOMC) is a case in point. In light of the sell-off in equity market, market participants were hoping for a “dovish rate rise”. Some even expected the Federal Reserve (the Fed) to pause its rate rising cycle. While the Fed did revise lower its ‘dots’ (signalling fewer future rate rises), comments by Chair Powell accompanying the increase in the fed funds rate were not dovish, driving market volatility even higher. Subsequently, Fed speakers turned more dovish, allowing markets to start rebounding slightly.

As markets slowly grasp that central banks are no longer underpinning asset valuations with their magic QE wand, sharper and sudden moves will likely become the new norm. The low volatility QE world many participants were used to is ending.

In some ways, this is a return to ‘normal’ (i.e., the QE world was an historical aberration). In the new normal, the emphasis will likely shift towards the fundamentals: macroeconomic data and corporate fundamentals will have a greater influence on price action. In this light, we note the deterioration in our aggregate US macro data quant signal: after being positive since 2012, it now stands at neutral. Clearly, markets have already priced in this decline, so whether the signal deteriorates further or improves from here will be key. We expect all eyes to be on the fourth quarter corporate earnings season, which is just starting.

 

What’s in the price?

What the market already prices is of course a key consideration. As discussed above, with macroeconomic data already deteriorating and equity markets around 20% off their year-ago highs, a lot of bad news is already in the price.

Put differently, previously elevated valuations have corrected sharply – e.g., the S&P 500 P/E ratio sagged from 20 points to around 14.5 currently, a level last seen in 2013.

Here our macroeconomic scenario, which models plausible states of the world given the available information and the potential evolution of various factors, comes in to play. As shown, for example, in Exhibit 5 for the S&P 500, US stocks have started pricing in the more bearish scenarios, but clearly, they could have further to run compared to our most bearish expectations.

We are at a crossroads, both in terms of the deterioration in the macroeconomic data and in terms of market pricing. In light of this uncertainty, we closed our tactical equity longs in December. We are structurally neutral on the asset class.

 

Exhibit 5: S&P 500 scenario analysis

sp500-scenario-analysis

Source: Bloomberg and BNPP AM, as of 09/01/2019

 

Looking at valuations and what is priced in, we note that EM equities have fared much better in recent weeks, not participating in the meltdown seen by G10 equities (Exhibit 6). Better valuations (read previous underperformance) have surely helped. Now that the market is also pricing out further Fed rate rises, there is further support for the asset class.

But as we have said before, to expect significant (outright) upside for EM assets, three conditions must be satisfied: i) a dovish Fed, ii) more policy easing in China, and iii) an easing of trade tensions between the US and China. On all three fronts, we are not yet convinced that enough progress has been made, but this remains on our radar screen for 2019.

 

Exhibit 6: EM equities outperforming recently

em-equities-outperforming-recently

Source: Bloomberg and BNPP AM, as of 09/01/2019

 


Views expressed are those of the Investment Committee of MAQS, as of January 2019. Individual portfolio management teams outside of MAQS may hold different views and may make different investment decisions for different clients.

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