Although the surge in volatility that shook the equity market in February was more technical than systemic, it revealed the new market environment. Fears about inflation, as perceived by investors, led to a volatility shock similar to that seen in China in the summer of 2015, at a time when the equity markets had become much less liquid and deep over the previous few quarters. This situation prompted traders who were short volatility to cover their positions, with immediate repercussions on asset prices. This type of sequence could recur, definitively ending the period of exceptionally low volatility seen in 2017.
No surge in inflation, but ongoing rate hikes need to be fully priced in
On the macroeconomic front, any fears of a sharp jump in inflation are probably overdone: it is probably more sensible to expect inflation and interest rates to normalise gradually. Economic growth remains robust and positive in all areas of the world – which is fairly rare – and has generally been stronger than expected at this late stage of the growth cycle. Business confidence remains close to its all-time highs, as shown by the Capex Plans index in the US.
Inflation has not yet reached central-bank targets and has a way to go to get there: core inflation in the US and eurozone remains below the official target. Given the current level of potential growth, inflation should have started rising three years ago. The fact that inflation and growth have been out of sync suggests that the link between them, as predicted by the Phillips curve, is fairly weak in the current cycle.
Although an inflation shock is relatively unlikely, the Fed is adopting a pragmatic approach to monetary tightening and is likely to keep raising official interest rates once per quarter this year. However, this tightening is not yet being fully factored in by the bond markets which, in recent years, have been consistently slow to price in rate hikes. This should cause investors to remain cautious regarding the duration of their bond portfolios.
Active management of duration, credit risk and stock selection
These conditions are conducive to active bond management, the aim of which is to achieve absolute returns, i.e. returns that are not constrained by benchmark indexes. The active approach is especially important given that euro aggregate investors still have little scope to deal with future rate hikes.
The first step is to adopt a dynamic approach to duration and credit risk. The aim is to reduce exposure to rising bond yields, and to break down that exposure between markets through global diversification of duration. In terms of credit allocation, the RASD (risk-adjusted spread duration) strategy gives the necessary leeway to adjust a portfolio’s sensitivity as market conditions change.
The ability to identify and exploit relative-value opportunities also allows active managers to optimise the risk/return and liquidity profile of their portfolios. One way of achieving this is by using derivative strategies, which are currently delivering higher carry and roll-down than traditional investment-grade bonds in both euros and US dollars.
Finally, the strength of a bond portfolio inevitably depends on careful selection of individual bonds and segments. From this point of view, investing in high-yield paper, globally and via CDSs, is a source of value. CDSs are cheaper than traditional bonds, as well as having lower duration and higher liquidity. Similarly, subordinated bank debt is an asset class that stands out because of its excellent fundamentals. The capital ratios of US and European banks are still solid, close to 12%, while the sector is becoming more profitable now that banks have settled most of their legal costs and are making more profit from client lending.
Christel Rendu de Lint
Head of Global & Absolute Return Fixed Income