Has Goldilocks left the building?

In response to the global financial crisis, central banks undertook unprecedented support for the financial system, including $US20 trillion in bond purchases, reducing interest rates to zero, and even cutting rates into negative territory across much of Europe and Japan. This contained environment of low rates, central bank bond purchases, and implied continued central bank support has been one of the key pillars behind the strong market reaction — one that saw not only risk assets hit new highs but also market volatility measures develop historical lows. Economic growth and inflation since the crisis have been in a generally stable range: Not too slow to suggest a repeat recession, and not too fast to encourage withdrawal of stimulus. The Goldilocks conditions of “just right” economics have been a perfect environment for most asset prices.

While real economic growth since the crisis has been subdued, low inflation has allowed central banks to keep their support at unprecedented levels. However, global monetary policy began to tilt away from easing in 2017, and this change is expected to be more pronounced in 2018. Quantitative easing (QE) purchases could be flat overall by the end of 2018, and policy could actually move to outright tightening by 2019.

We have seen some early glimpses of the impact on risk assets of less accommodative policy from the central banks and they beg the question: How do we approach investing in this new phase in financial markets?

Has Goldilocks left the building?

Where are we?

In order to determine the appropriate approach to investing in 2018 when less support from central banks may result in a rise in volatility, we must first assess where we are.

Growth improved through 2017 and accelerated into year end and early 2018. This has been supported by improved sentiment on the back of US tax reform legislation and potential infrastructure investment. The chart below shows that all 45 countries in the Organisation for Economic Co-operation and Development (OECD) survey are in expansion — a rare occurrence.

OECD expansion, contraction, and growth indicator

OECD expansion, contraction, and growth indicator

Source: OECD.

This improvement in fundamental factors is also evident at the corporate level and can be seen with the acceleration in earnings per share (EPS) growth in the chart below.

S&P 500® Index EPS growth

S&P 500 Index EPS growth

Source: Datastream; data through Feb. 23, 2018.

This fundamental backdrop gives us comfort that the immediate recession risk is low and that the general outlook for investing in credit is solid. However the recent period of low yields, ample liquidity, and low volatility has seen valuations move into the expensive range. The historical chart of investment grade credit spreads below shows this. We are yet not through historical tights in credit spreads but there is clearly limited upside.

Investment grade historical valuations

Investment grade historical valuations

Source: Bloomberg and Macquarie; data through Jan. 24, 2018.

What might be changing?

We noted above that we are likely entering a period of less supportive central banks, as economies show early signs of standing on their own two feet and seek to get away from emergency levels of interest rates and bond purchases.

Recent announcements from three of the major global central banks have signaled their intentions to be less accommodative:

  • The US Federal Reserve has indicated its monetary policy stance will continue to skew towards more interest rate hikes even as it proceeds on its pre-announced move to reduce its balance sheet.
  • The European Central Bank’s QE tapering should continue for the next 12 months but is unlikely to accelerate.
  • Some indication of the Bank of Japan’s preferences for tightening, if not yet in outright tightening, was hinted at by the slowing pace of financial asset purchases in 2017, with the most recent month posting a net selling of assets.

The unwinding of central bank balance sheets and support through low or emergency levels of interest rates could constitute, in our view, a completely new market environment because there are no sample observations to analyze significant global central bank shrinkage and its impact on asset markets.

Against this backdrop, we can’t tell how asset markets will react, but recent events do indicate that as asset markets adjust to this less supportive environment, we should see volatility pick up during 2018. If central banks do not implement withdrawal of support in unison, we may see the same kind of effects on currency markets such as occurred in 2014 and 2015 as a result of divergent monetary policy.

We may also see a change to the supportive technical backdrop. An example of this could be found in offshore investors buying US dollar corporate securities (one of the key buyer groups in recent years) and who may find these securities less compelling on a fully hedged basis — which may reduce another supportive technical force.

Yields have risen, but in a historical sense we are still in a low yield world. This, combined with tight credit spreads, means that the buffer to absorb spread widening is thin. In the case of idiosyncratic events, this means that deep fundamental research on the securities in which you invest is more important than ever. The example of Teva Pharmaceuticals in the chart below illustrates the spread over Treasurys, which is the additional return required for taking on the risk of this corporate name. Here you can see that this required spread increased from lows of 141 basis points to as high as nearly 347 basis points. This shows that getting the call wrong can cost you — in this case, about nine years of excess return.

Case study: Teva’s spread, or additional return needed, over time

Case study: Teva’s spread, or additional return needed, over time

Source: Bloomberg; data through Nov. 30, 2017.

Flexibility is key

Traditional fixed income investing is tied to a benchmark, which generally includes exposure to interest rate duration, is heavily weighted to lower yield government securities, and is usually constructed to give the largest borrowers the largest index weighting. Without the structural ties of a benchmark, absolute return strategies have the flexibility to hold only the securities and sectors that have a positive return outlook for the prevailing environment. This flexibility also gives the ability to be less constrained by a benchmark and move to a more defensive stance, if the outlook indicates that there is not enough reward for risk.

A diverse investment universe, which offers the ability to invest right across the credit spectrum (including investment grade, high yield, bank loans, emerging markets, and structured products) without being bound by fixed allocations, allows an investor the luxury to rotate sectors. When there is no compelling risk for reward, investors can reduce exposure to riskier sectors, and when there is plenty of reward for risk on the table (indicated by higher credit spreads), they can make a significant allocation to the sector.

The chart below highlights how this flexibility can work for an investor as the best performing and worst performing sectors can vary significantly from year to year.

Asset returns: Risk outperforms US Treasurys

Asset returns: Risk outperforms US Treasurys

Source: Barclays, JP Morgan, and Bloomberg. See Information at end for index descriptions.

Past performance is not a guarantee of future results. Indices are unmanaged and one cannot invest directly in an index.

Conclusion

A supportive fundamental backdrop is giving central banks the luxury to make progress on exiting the extreme support that they have been providing to global economies and financial markets. With these actions likely to lead to an increase in volatility, traditional strategies may be exposed, with many assets priced to perfection.

More flexible strategies, without the structural ties of a benchmark, may provide a better pathway for investors to achieve target returns. Investors can avoid exposure to certain sectors when there is no reward for the risk, and tilt the portfolio to take advantage of the returns available where there may be reward on offer. The prevailing structural forces in 2018 could see Goldilocks leave the building, but a flexible strategy may provide returns that are just right.


As of Mar. 7, 2018, certain securities discussed were held in portfolios managed by the team as follows (in amounts up to): Teva Pharmaceuticals, Diversified Income Fund (emerging markets sleeve), 0.92%; Emerging Markets Debt Fund, 0.91%; High Yield Opportunities Fund, 0.29%; and Corporate Bond Fund, 0.17%. Amounts shown are for informational purposes only, and subject to change at any time. They are not a recommendation to buy, sell, or hold any security.

The views expressed represent the Manager's assessment of the market environment as of March 2018, and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the Manager's views.

S&P 500: The S&P 500 Index measures the performance of 500 mostly large-cap stocks weighted by market value, and is often used to represent performance of the US stock market.

High yield: The Bloomberg Barclays High-Yield Municipal Bond Index measures the total return performance of the long-term, non-investment-grade tax-exempt bond market.

Treasury: The Bloomberg Barclays Long U.S. Treasury Index measures the performance of US Treasury bonds and notes that have a remaining maturity of 10 or more years.

Agency: The Bloomberg Barclays US Agency Index is composed of publicly issued debt of US government agencies, quasi-federal corporations, and corporate or foreign debt guaranteed by the US government. The largest issuers are Fannie Mae, Freddie Mac, and the Federal Home Loan Bank System (FHLB).

Agency MBS: The Bloomberg Barclays US Mortgage-Backed Securities (MBS) Index measures the performance of agency mortgage-backed pass-through securities (both fixed-rate and hybrid adjustable-rate mortgage) issued by the Federal National Mortgage Association (Fannie Mae), Federal Home Loan Mortgage Association (Freddie Mac), and Government National Mortgage Association (Ginnie Mae).

EM Debt: The J.P. Morgan Corporate Emerging Markets Bond Index (CEMBI) Broad Diversified Index tracks US dollar-denominated emerging market corporate bonds, limiting the weights of countries with larger corporate debt stocks by including only a specified portion of those countries’ eligible current face amounts of debt outstanding.

Corporate: The Bloomberg Barclays Long U.S. Corporate Index is composed of U.S. dollar–denominated, investment grade, SEC-registered corporate bonds issued by industrial, utility, and financial companies. All bonds in the index have at least 10 years to maturity.

CMBS: The Bloomberg Barclays US Commercial Mortgage-Backed Securities (CMBS) Index measures the market of commercial mortgage-backed securities.

IMPORTANT RISK CONSIDERATIONS

Investing involves risk, including the possible loss of principal.

Past performance does not guarantee future results.

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