The rally in global equities since last summer has been driven primarily by the wave of liquidity provided by central banks. This wave will not last forever. We have seen the first indications of an exit strategy from the US Fed. As it has done since the Global Financial Crisis began, the US central bank will set the template for its peers when it decides to withdraw stimulus and move towards re-establishing a more ‘conventional’ relationship with its economy. The signs are that a return to ‘normality’ is tentatively underway, and this is no bad thing if growth continues to improve steadily. Since 2010 global economic expansion has been somewhat disappointing, but at the same time it has not been so fragile that there has been a real danger of renewed recession. This type of ‘Goldilocks world’ that we have been inhabiting has been a relatively benign one – banks have kept the wolves from the door while the porridge warms on the stove.
Duration, duration, duration…
For some time, we have been assessing the potential vulnerability of bond portfolios if the outlook for rates changes dramatically. If the world economy continues to heal as we think it will, bonds will have less appeal than they have had in the past. If a substantial weight of money begins to rapidly exit the bond markets, liquidity issues could resurface. Making the correct call on fixed income exposure could potentially be more important in terms of asset allocation than equity sector and regional positioning within multi-asset portfolios. For example, we currently have very limited exposure to conventional gilts or US treasuries, preferring corporate bond funds with short maturities and flexible mandates.
The intensifying search for yield has been leading investors to the higher risk end of the corporate bond markets. The valuation argument for high yield corporate bonds continues to centre upon their spread to government debt: the continuation of current central bank policies has been instrumental in suppressing interest rates and bond yields, supporting equity markets and keeping corporate defaults low. However, high yield bonds have seen significant inflows, and it is becoming more difficult to argue that their coupons provide sufficient compensation for risks taken by the investor, especially in the event of rising rates. Similarly, emerging market debt is another area of concern for us.
…Location, location, location
Partly as a result of our views on the potential dangers in the bond market, we have been shifting some of our exposure into property. In some respects, property can be perceived as a ‘stepping stone’ asset for investors who are looking to rotate out of bonds, but who are not yet comfortable investing in equities. It offers a similar yield to high yield bonds, but with arguably fewer valuation concerns. In comparison to a considerable sum of money that has been parked into bonds over the past few years, property has had very little direct investment. Although we do not expect much in the way of capital gains in the short run, running yields from commercial property are relatively attractive. We anticipate a yield in the area of 4.5%-5% over the course of a year if achieved through carefully managed strategies.
Opinion column by Bill McQuaker, Deputy Head of Equities for Henderson Global Investors.