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A changing fixed-income world: asset allocation challenges

Investment strategy

Maximilian MOLDASCHL
 

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  • Change of regime? As markets face quantitative tightening in the months and years to come, signs are that we are on the brink of a change in regime across major asset classes. This year, we already saw two episodes where a bond market sell-off caused an equity market correction.
  • US yields moving higher – We believe that US yields are moving structurally higher – with 10-year US Treasury (UST) yields already breaking out of a multi-decade bull market trend for fixed income. This is driven by: i) strong US growth, ii) expansionary fiscal policy and more bond supply on the horizon, iii) less foreign investor demand for USTs, iv) the US Federal Reserve moving into restrictive territory and v) depressed real rates and term premia reversing.
  • Equity/bond correlation shifting into positive territory? Perhaps the most important implication for cross-asset investors and asset allocators is a possible shift in the equity/bond correlation. We find that broadly speaking, the mainly negative correlation between the two asset classes witnessed since the 1990s is a function of (low) inflation and compressed term premia, both of which could pick up as we move away from quantitative easing (QE). More recently, we have seen bond markets rallying little during equity market corrections. Put differently, bonds have been the source of equity sell-offs and as such they offer less protection to cross-asset portfolios.
  • Worse risk-adjusted returns ahead – We believe that the future likely comprises weaker returns than during the height of QE, and importantly also more market volatility. Sharpe ratios for buy-and-hold investors are thus likely much lower than what many market participants have become used to. For us as asset allocators, this means being ever more tactical in managing portfolios.
  • ‘Asset-pickers’ to benefit – The unwinding of QE should also help reverse currently high correlations between asset classes. This suggests a return to an environment favouring ‘asset-pickers’ where portfolio managers can add more alpha again.

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