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After a painful transition away from the lower-for-longer environment, fixed income appears to have regained its footing. Bonds look attractive from both a diversification and income perspective, with yields at multiyear highs across all sectors. So far, so good, but the recent US regional bank crisis is the latest in a series of events that remind us that bond investors face a new, more volatile normal.
This new macroeconomic regime will likely present shorter and more pronounced cycles and a greater occurrence of idiosyncratic risk — whether from country, sector or individual issuer. In this environment, we think combining the flexibility offered by active management with greater diversification based on fundamental research may be key to future success. An important consideration in this context is the role of geographical diversification.
Actively pursuing global fixed income opportunities may be particularly attractive for European investors at this juncture. Rates across Europe appear to have upward momentum relative to the US, while hedging costs may become materially lower.
Until recently, the direction of yields in European core fixed income seemed to be a permanently downward path leading to years of outflows. Now, yields in European sovereigns have returned to relatively attractive levels and outflows have petered out. Conversely, global allocations have been punished by the strength of the US dollar, suggesting that for European bond investors, home remains the best place to be. However, looking ahead, we think that diversifying domestic or regional exposures may be more rewarding for European bondholders. On the face of it, this goes against sticking to established approaches during periods of recession. However, we would caution that the next recession is likely to look very different from what we have been used to in the past. In our view, the new regime creates four compelling reasons for fixed income investors to seek global diversification.
1. Access opportunities across an inconsistent global policy landscape – Central banks are at different stages of the cycle. As a consequence of the regional US banking crisis, the US may potentially face a meaningful tightening in credit conditions. This potential credit squeeze may prompt the Federal Reserve (Fed) to end its hiking cycle ahead of other major central banks, notably the European Central Bank (ECB). In Europe, bondholders have also benefitted from a decade of significant purchases by the ECB as part of its asset and pandemic emergency purchase programmes. Figure 1 illustrates the sheer scale of that support.
The reversal of that support, as the ECB starts to reduce its balance sheet, along with further monetary policy tightening, could represent a significant headwind for European rates. And unlike in the US and the UK, where fiscal policy is expected to tighten, budgetary policy across much of the European Union is projected to remain expansionary, creating further momentum for higher rates.
2. Position for less predictable inflation ahead – By keeping rates in restrictive territory, the Fed could significantly reduce inflation by slowing US growth. On the other hand, China’s reopening could be a tailwind for global growth and commodities, making the outlook for inflation much muddier than in prior US recessions. In this environment, home biases may be overly reliant on past assumptions; for example, over the past decade the euro area has been a source of disinflation for the world. This appears to be reversing, with headline and core inflation now consistently above the G7 average (Figure 2).
3. Take advantage of opportunities to navigate volatility and event risk – We see elevated levels of volatility and continued event risk on the horizon, such as the potential for further difficulties in pockets of the banking system and other sectors dependent on credit lending, the continuing war in Ukraine and multiplying instances of social and political instability as populations across the world face a growing cost-of-living crisis. Pivots in central bank policy may generate opportunities but also risks: most notably the Bank of Japan’s (BOJ’s) imminent exit from its long-standing policy of yield curve control. Designed as a stimulus mechanism to sustain inflation in Japan, it resulted in Japanese institutions purchasing billions’ worth of European bonds to generate positive returns — a reversal could be a further headwind for European fixed income.
Over the last decade, European bonds have benefitted from significant purchases by the European Central Bank, as part of its asset purchase and pandemic emergency purchase programmes, which have totalled €5 trillion in purchases since 2014. As ECB monetary policy tightens and the balance sheet is gradually unwound, this could represent a significant headwind to European rates, as the marginal buyer is no longer there, at the time where expansionary fiscal policy means record new issuance. These events are all trigger points for renewed volatility, which active diversification across different regions may help mitigate.
4. Benefit from lower hedging costs – Europe’s stronger-than-expected growth and high inflation will keep pressure on the ECB to continue its hiking cycle. As the ECB catches up to the Fed in its monetary tightening cycle, a reduction or tightening in US-Europe short-term rate differentials should contribute to lower hedging costs for Europe-based investors investing in global fixed income markets. European fundamentals remain fairly resilient — corporate profit margins have recovered, periphery unit labour costs have normalised compared to core Europe and consumer real incomes are improving. In our view, these factors support continued outperformance of the euro and most other European currencies versus the greenback, and lower hedging costs as a result.
Managing global exposure effectively requires a specific skill set, combining a deep understanding of global and local markets with macro and geopolitical expertise. Moreover, we believe an active approach based on fundamental research can provide investors with greater flexibility to deal with today’s complex and uncertain environment where further volatility-spiking events are likely. An active approach may be particularly relevant for European investors, as they navigate a very different policy environment with significant divergence between countries and sectors.
Most investors tend to be susceptible to a domestic bias and have often been rewarded for sticking close to home. However, we think there is now a growing imperative for European investors in particular to go global as we believe it may help protect portfolios against country-specific volatility and preserve yields. Doing so actively may offer further risk and return benefits. While the level of appropriate global exposure will vary depending on an investors’ specific circumstances, we think it is timely for most to revisit their portfolios as we enter a structurally different regime that is likely to challenge many tried and tested approaches.
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