Government bond markets performed well as equities dropped in response to weakening economic data, reinforcing the “bonds are back” narrative.
Traditionally, investing in high-quality, long-duration government bonds has been effective as a defensive risk balance for the equity or growth-oriented side of investment portfolios. While this idea fell out of favour in the era of zero interest rates and ultra-low bond yields, it now has renewed interest with bond yields rising.
In bond markets today, the focus is either on trying to predict how the future path of interest rates will impact bond market performance or on the “bonds are back” narrative, as it relates to multi-asset investment portfolio construction.
The usual flood of macro commentary, focused on when and how much central banks will cut rates in response to weakening economic data, has flooded the market in response to recent volatility.
This renewed narrative catalysed a strong rally in long-duration government bonds as markets shifted to pricing in an expectation for lower future interest rates. The rationale, lower rates = lower bond yields = higher bond prices.
Just a few weeks prior, much of that same macro commentary was focused on the opposite scenario. One where resilient economic growth keeps inflation elevated and prevents central banks from cutting rates. In the case of Australia, it actually forces the RBA to increase rates further. This was the so-called “good news is bad news” narrative.
When it comes to forecasting macro variables, such as economic growth, inflation, the path of interest rates, etc, there is ample evidence that forecasters get it wrong as much as they get it right. This is because reliably forecasting macro variables is an impossible task. There are just too many inputs, feedback loops, and random confluences of events to account for. While macro variables are certainly important, their future path is unknowable and unreliable.
In portfolio construction, many investment decisions are implicitly based on macro forecasts, without explicitly acknowledging this is the case. This creates risk, especially in the face of uncertainty.
The conventional “bonds are back” narrative certainly holds up in classic economic growth shock scenarios. This is where central banks cut rates due to recession risk, triggering strong gains on long-duration bonds. However, as we are now in a regime of elevated inflation uncertainty, there is a range of realistic macro scenarios where this narrative will not hold true.
Market dynamics in 2022 provided a stark reminder of this, when both equity and bond markets simultaneously incurred large losses. Importantly, over this period, long-duration government bonds exhibited equity-like volatility, which further undermined their effectiveness as defensive risk diversifiers.
Looking forward, inflation uncertainty remains high. This is evident in the extreme variability of market pricing in short-term interest rates, which reflects consensus expectations for the future path of rates. It is also evident in measures like the US Federal Reserve’s inflation uncertainty index.
In regimes of elevated inflation uncertainty, the conventional approach of using long-duration government bonds to hedge equity risk may still work, but it is not as reliable across the broad range of realistic scenarios we now may be facing.
Additionally, there are several tail risks front of mind for government bond investors. This includes rising government debt levels, increased government bond supply versus reduced bond buying from central banks, and elevated risks from populist government policies.
Therefore, relying on only a single lever of duration to diversify equity risk embeds an implicit macro forecast. This a risky bet to make given how unreliable macro forecasting can be, particularly in regimes of elevated inflation uncertainty.
An alternative approach is to instead focus on building portfolios that are resilient to a wide range of possible outcomes.
In fixed income, this means broadening the toolkit to complement the conventional duration lever with lesser-known investments that exhibit consistently low volatility and correlation to broader equity and bond market performance, while also exhibiting a strong bias to outperform when equity and bond markets incur losses.
While bonds may be back in the face of global market volatility, it pays to be selective and not hedge your bets on the market crystal ball.
Gopi Karunakaran, co-chief investment officer, Ardea Investment Management
