Recent market volatility suggests that investors are questioning whether the post-crisis subpar pace of economic growth, which we dubbed the New Normal, is subsiding, to be replaced by more traditional late-cycle outcomes – in particular faster inflation and tighter monetary policy.
We believe that U.S. economic growth will likely accelerate to 2.5% or so this year, and that faster growth along with high levels of resource utilization – i.e., tight labor markets – will boost inflation and compel the Federal Reserve to implement more rate hikes than are currently priced in by the fixed income market. We would not, however, dismiss either the New Normal or The New Neutral, our term for an era of low global policy rates, just yet.
That said, we are mindful of the impact that a rising U.S. budget deficit and fading Federal Reserve support may have on market interest rates, and we believe it is an important factor to consider when constructing a fixed income portfolio. For example, we would expect investors to demand increased compensation for future risks, as reflected in term premiums for U.S. Treasuries as shown historically in Figure 1.
Nevertheless, we believe powerful forces are working against a permanent increase in the trajectory of economic growth in the U.S., including the aging population, productivity trends, sovereign indebtedness, credit growth, and an imbalance between savings and investments.
Moreover, many nations, and in particular those within the eurozone, remain several years behind the U.S. in their economic cycles, which will limit the extent to which global central banks can move away from their extraordinary monetary accommodation.
Therefore, absent a permanent increase in the trajectory of U.S. economic growth and a faster reversal of monetary accommodation abroad, market interest rates are more likely to be contained than break significantly higher.
We suggest bond investors consider the following action plan:
- Neutralize equity risk by holding core bond strategies tied to the Bloomberg Barclays U.S. Aggregate Index, which today yields about 3%. Income and unconstrained strategies tend to be good diversifiers, too. Think more about prudent portfolio construction than about where U.S. rate increases will stop.
- Be forward-looking about equity and credit beta. Think ahead, and gear investment portfolios to handle stress. Be a liquidity provider today, not a taker – reduce risk.
- Don’t worry too much about rising rates – they have already moved a lot and likely won’t rise much more. Higher rates while potentially painful in the short-run are good for bond investors in the long run. It’s simple math. It does not necessarily need to be a reason to stop investing. Don’t try and market-time the diversification benefits of bonds. Maintaining a hedge against risk is important!
Finally, recognize that in today’s $110 trillion global bond market there are a multitude of differences among bonds and therefore many potential sources of attractive returns, many having little reliance upon the macro situation. There are also many moving parts, making this is a great time for active management.
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