October’s Bank of America Merrill Lynch global fund manager survey revealed that, with a net 80% underweight position, allocations to bonds have slumped to an all-time low.
Based on concerns surrounding inflation and pessimism about China, and for the first time since April last year, October’s survey revealed that global growth expectations had turned negative, with a net 6% of managers predicting the global economy will weaken in the next 12 months.
Set against such a backdrop, allocations to cash and commodities surged, equity positions were unmoved, but bond investors continued to head for the exit door.
So, is now the time to be giving up on bonds, or are there still opportunities within the asset class?
Inflation woes
At the start of Q4 last year, Iboss investment and managing director Chris Metcalfe says the firm expected most, if not all, fixed income to produce negative returns in 2021.
“As we start the fourth quarter of 2021 that position hasn’t changed,” he says. “We have been systematically decreasing duration across the asset class. At the same time, we removed our explicit holdings in treasury’s and hold our smallest allocation to gilts since our inception in 2008.”
Metcalfe says Iboss’s fixed income stance is predicated on its belief that inflation is not transitory, and whil nothing goes up in a straight line, he believes future inflation remains underpriced in bond markets.
“This doesn’t mean that yields have to move up to more than, say, 3% plus on the 10-year gilt or Treasury, but it does mean there will be more upward pressure in the coming quarters,” he says.
Metcalfe adds the factor that makes him most uncomfortable about sovereign bonds more generally is that, unlike most of the period since the global financial crisis, he says central banks could find themselves somewhat “impotent” in their ability to hold down yields.
“Many governments and central banks alike are at pains to point out they are happy with higher inflation, and whilst they need to be careful what they wish for, upward pressure on bond yields is likely to continue,” he says.
Where Metcalfe does see some opportunity within fixed income is with some strategic bond funds – albeit limited. He says Iboss currently uses three active funds across its Core range: Baillie Gifford Strategic, Rathbone Ethical and Twentyfour Corporate bond funds.
“These are supplemented by passive shorter-dated UK bond funds and passive global funds,” he adds. “With interest rates still near zero, it remains challenging in the short term bond space for active managers after fees to outperform their passive peers, hence allocating passive funds.”
Under pressure
Adrian Lowcock, independent wealth consultant, says fixed income has been under pressure in recent weeks.
“The Evergrande default in China is weighing on the market but seems to be a slow default,” he says. “Whilst the global market has largely taken the crisis in its stride, the risk of contagion remains a concern.”
More importantly to UK and western investors, says Lowcock, is the potential for higher inflation and the subsequent response by governments and central banks to keep it in check.
“The outlook for fixed income going forward depends more on the outlook for inflation and the global economy,” he says. “Inflation is high and much higher than government targets as well as staying persistently higher than the same institutions.”
For Lowcock, the biggest risk to bonds is the stagflation, namely low growth and high inflation. He notes high yield bond issuers are more likely to suffer in this situation as they have less room manoeuvre.
“Government debt remains very low yielding, often negative and simply unattractive for investors, with the risk that should central banks lose control of inflation then yields could rise substantially,” he adds.
Like many participants, Lowcock says the fixed income market is currently waiting to see the direction of travel and what are the central banks going to do.
“The Bank of England looks like it may have no choice but to raise rates sooner rather than later – which could be bad for the bond market in the short term, but may well quash the recovery and be short lived as rising oil prices, removal of furlough and other covid support payments also hit household incomes,” he says.
“The US is likely to be more patient and introduce tapering before raising rates, willing to let inflation over run for a while,” he adds. “However if inflation remains higher for longer then we could see the bond market begin to underperform especially if the oil price remains consistently high as it will weighs on economic growth in 2022.”
