The normalisation of the equities v bonds correlation
It’s been a strange time for bonds and equities – over recent years the traditional negative correlation which sees bonds rise when equities fall and vice versa has been nowhere in sight, distorted by the focus of both markets on the inflationary cycle and the central bank reaction to that cycle.
However, the recent loss of momentum in the US economy and the weaker than expected US employment data has fuelled fears of a US recession, led to a reappraisal in some quarters of when the Federal Reserve (Fed) will start cutting rates, and also given a healthy boost to bond markets. Amid the market turmoil of the past week or so, the role of bonds as a valuable diversifier is again in the spotlight.
While there has been no collapse in US economic activity, rather a slowdown in the rate of growth, this, combined with the Bank of Japan’s recent unexpected interest rate hike and its subsequent impact on global carry trades – where investors borrow cheaply in one currency to benefit from higher returns on investments in another currency – has contributed to an increasingly volatile market for equities.
Key for investors is that we are now seeing the transition to a negative correlation again between bonds and equities, which suggests that markets are thinking more about growth than inflation, consistent with the message we have been seeing from central banks.
For the last two years the Fed has been laser focused on inflation. However, we believe it is now acknowledging the economic slowdown and may decide to ease up on monetary policy to make it less restrictive than it has been to date.
A market overreaction or a real risk?
A factor driving the recent market reaction is the so-called Sahm Rule. This statistical observation suggests that whenever the three-month average unemployment rate rises by half a percent or more, it signals the start of a recession. However, the Fed’s Chair Jerome Powell has dismissed the significance of this, arguing that unemployment is growing because there has been a big growth in the US labour force due to high net migration – as opposed to mass layoffs.
Now is a great time for investors to look again to bonds as a diversifier. The market had overreacted to one set of US employment data but has unwound a lot of that overshot over the past week. The direction of travel seems clear – the Fed is going to accelerate the rate at which it cuts rates and arrive at neutral fairly rapidly. Despite this, we would argue that the markets’ attempt to push for an emergency rate cut soon, or a 50bps in September, did feel like an overreaction.
Because the market is starting to expect rate cuts, a big steepening of the US yield curve has begun, which has seen 2-year yields fall sharply against 10-year yields. This is taken as a sign by some of imminent recession as the prior yield curve inversion approaches its end. It has also been one of the potential causes of equity market rotation, of the growth vs value debate, as the changing shape of the yield curve puts a greater premium on earnings earned sooner rather than later.
Yet we still believe that there will be at most a mild recession. Consumption is about two-thirds of US GDP and, with the US consumer in generally good shape, it’s hard to generate a deep recession.
The one exceptional tail risk to this is if unemployment dramatically surges, then that will clearly affect consumer spending, while US savings are also at a very low level.
Value in bonds
The risks of a recession are prompting the rotation away from global equities and fixed income is now back in its place as a diversifier. Of course there are risks, such as some payback in August’s labour data and the ongoing political Trump risk, but for anybody who wants to buy bonds for the longer term, the economic signs are aligning.
There is good value in both nominal and real yields, and there is the chance of further capital upside as the rates cutting cycle accelerates over the coming months.
The shift from the tunnel vision of inflation to a focus on inflation and growth means a return to the ‘same as it used to be’, a normalised world for bonds – something investors should welcome.
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The Funds managed by the Global Fixed Income Team:
Consider environmental, social and governance (""ESG"") characteristics of issuers when selecting investments for the Funds. May hold overseas investments that may carry a higher currency risk. They are valued by reference to their local currency which may move up or down when compared to the currency of a Fund. Hold Bonds. Bonds are affected by changes in interest rates and their value and the income they generate can rise or fall as a result; The creditworthiness of a bond issuer may also affect that bond's value. Bonds that produce a higher level of income usually also carry greater risk as such bond issuers may have difficulty in paying their debts. The value of a bond would be significantly affected if the issuer either refused to pay or was unable to pay. May encounter liquidity constraints from time to time. The spread between the price you buy and sell shares will reflect the less liquid nature of the underlying holdings. May, under certain circumstances, invest in derivatives, but it is not intended that their use will materially affect volatility. Derivatives are used to protect against currencies, credit and interest rate moves or for investment purposes. There is a risk that losses could be made on derivative positions or that the counterparties could fail to complete on transactions. The use of derivatives may create leverage or gearing resulting in potentially greater volatility or fluctuations in the net asset value of the Fund. A relatively small movement in the value of a derivative's underlying investment may have a larger impact, positive or negative, on the value of a fund than if the underlying investment was held instead. The use of derivative contracts may help us to control Fund volatility in both up and down markets by hedging against the general market. The use of derivative instruments that may result in higher cash levels. Cash may be deposited with several credit counterparties (e.g. international banks) or in short-dated bonds. A credit risk arises should one or more of these counterparties be unable to return the deposited cash. May invest in emerging markets which carries a higher risk than investment in more developed countries. This may result in higher volatility and larger drops in the value of the funds over the short term. May be exposed to Counterparty Risk: any derivative contract, including FX hedging, may be at risk if the counterparty fails. May target an absolute return. There is no guarantee that an absolute return will be generated over the time period stated in the fund objective or any other time period. The risks detailed above are reflective of the full range of Funds managed by the Global Fixed Income Team and not all of the risks listed are applicable to each individual Fund. For the risks associated with an individual Fund, please refer to its Key Investor Information Document (KIID)/PRIIP KID.
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