Bonds are back, but are less reliable

By Jayson Forrest

Richard Rauch (Brandywine Global Investment Management) and Dominic McCormick discuss the outlook for medium-term returns, and what this means for positioning portfolios from a global perspective.

In setting the framework for positioning portfolios from a global perspective, Investment Consultant, Dominic McCormick, believes that when building and managing portfolios, there are four key considerations for portfolio constructors and investment committees. These are:

1. Understanding the challenge in equity markets.
This is in respect to the over-valuation of equities, the over-concentration of equities in portfolios, and the over-confidence that many investors have with their exposure to equity markets and with the larger stocks within indices.

2. Inflation and interest rate uncertainty.
While inflation may be receding as an issue amongst investors, inflation protection in portfolios is still a key factor to consider.

3. Private markets.
The inclusion of private markets in portfolios provide opportunities but also challenges, given the illiquidity aspect of these assets. There is also the risk of expecting too much in relation to what these assets can deliver, especially in more stressed environments. 

4. Geopolitical issues.
This is particularly the case when major powers start going ‘head-to-head’ in ‘hot and cold wars’, which has a considerable impact on markets. 

It’s a view shared by Richard Rauch, CFA — Investment Director at Brandywine Global Investment Management. Speaking at the 2024 IMAP Independent Thought Conference on the outlook for medium-term returns, Richard concedes bonds have been a difficult sell lately, with “a tough run for duration”, but he believes “bonds are back”.

However, while he says the medium-term outlook for bonds is reasonable, delivering decent real returns around the world, he cautions that from a defensive portfolio perspective, they are now less reliable in portfolios since the COVID pandemic. That’s because since the COVID outbreak in 2020, markets have not been in a normal cycle. Instead, Richard says what we’re currently experiencing is a normalisation from a natural disaster.

“The pandemic was much more complicated than a normal natural disaster, like an earthquake or tsunami. The COVID pandemic was global, which saw an extraordinary amount of monetary and fiscal policy response around the world.

“It’s taken us to about now for market normalisation to return, with the last piece of that being inflation. So, everything that went up in sequence, has largely come down in sequence, but overall, it’s taken a lot longer to happen than most people thought,” he says. “Bond markets are now trading on the premise that victory can be declared on inflation being well-behaved throughout this cycle.”

However, if there is a medium-term risk of inflation remaining elevated, what does that mean for duration and the role of products like inflation-linked bonds? 

“It’s an interesting question,” says Richard, who acknowledges that inflation is bad for most bonds. While the short-term expectation is for inflation to drop, he says over the medium to long-term, the forecast for inflation remains unclear. “That’s because there are risks in the market, which are mainly coming from fiscal policy.”

From an economic growth perspective, he points to the U.S. as being the standout performer, at least in the developed world. In comparison, Australia has been in a per capita recession for at least two years, while New Zealand and most of Europe have been in and out of recession, and China has been in a deflationary environment. “So really, the only above trend market in the world has been the U.S. and a lot of that has been fiscal driven in terms of the outperformance.”

Richard believes the U.S. matters significantly in terms of the future outlook for inflation, with much of that depending on fiscal policy. In relation to what that means for bonds, he believes that over the short-term, falling inflation will be bullish for bonds, which explains why bond yields have been falling. He expects that will continue to happen globally throughout the back end of 2024.  

“In terms of inflation-linked bonds, breakevens have fallen by a decent amount. If you can get close to 2 per cent real yield on an inflation-linked bond and you have a CPI-plus 3-3.5 per cent target, and you add some private credit, then your portfolio is well-positioned. So, it’s currently a pretty good environment for the bond market, but over the long-term, a lot will depend on future growth and inflation.”

When considering spiralling government debt globally, Richard’s long-term outlook is not good, particularly when considering the U.S., which is in debt by US$35 trillion. 

“U.S. GDP is about US$30 trillion, and actual debt to GDP is slightly less than it was during the pandemic, which is a positive. However, U.S. debt remains a real worry. Perhaps with all that debt in the system, there’s a limit for how high growth and inflation can go, which might keep a cap on things — at least for the time being,” says Richard.

“In terms of U.S. politics, something that Joe Biden, Kamala Harris, and Donald Trump all share in common is they are ‘populists’, and populists like nominal growth. They like giving people money through tax cuts and social programs, which is dangerous considering the U.S. is running the biggest fiscal deficit we’ve ever seen, outside of a couple of major recessions and the Great Depression.”

Despite the fiscal situation of the U.S., some emerging countries are in much better fiscal shape, which Richard believes does provide investors with opportunities. He says that historically, the emerging world has not had the luxury of having their fiscal house in order and as such, have been punished by markets. However, in the current cycle, many emerging countries have got their economies in order and in so doing, have been able to tackle inflation much faster than the developed world.

Richard points to Latin America, with countries like Brazil, Columbia and Mexico, all hiking interest rates much faster than the developed world. This has enabled these countries to get on top of inflation quicker, which has allowed them to now lead the world in cutting interest rates.

“Some of these emerging countries have been the best performing markets globally, particularly when you add in the effect of their currencies appreciating, and the bond market performing well. So, by getting their fiscal houses in order, some of these emerging markets are great places to be invested.”

When it comes to positioning portfolios from a global perspective, Brandywine believes it is essential to better understand the global economy, with three important areas to consider being:

1. Understanding the U.S. economy — a US$30 trillion economy, making up the world’s biggest capital markets.

2. Understanding China — what is likely to play out politically and economically in China.

3. Understanding the U.S. dollar.

“We believe if you figure out those three key areas, then everything else falls into place,” says Richard. “The U.S. dollar looks expensive, but that doesn’t mean it can’t stay expensive or become even more expensive. The U.S. has the luxury of being the reserve currency around the world, and we don’t think that’s changing.

“That said, from a low cyclical perspective, what drives currency performance is relative growth differentials. Over the last decade, the U.S. has been outperforming from a growth perspective. These cycles tend to go for 10 years at a time. We do think the cycle is rolling over and the U.S. dollar has peaked, and the next trend — probably for a decade — will be U.S. dollar underperformance.”

And what about other global currencies?

Richard says when looking at China and Europe, these markets already have low market expectations, despite Chinese equities trading at 9x earnings and European equities generally also looking good.

“All these countries (including emerging markets) have to do is exceed our low expectations for their currencies to do better, relative to the U.S. dollar,” he says. “Closer to home, the Australian dollar has lagged relative to the U.S. dollar. However, we think that will go in the other direction, and it’s already started to happen.

“As the U.S. starts cutting rates, interest rate differentials change, so the effect of hedging becomes a lot more palatable. This means you’re not paying as much to hedge your U.S. dollar portfolios or foreign currency portfolios.”

Richard Rauch, CFA is Investment Director at Brandywine Global Investment Management; and

Dominic McCormick is an Investment Consultant.

They discussed the ‘Outlook for medium-term returns and setting the portfolio accordingly from a global perspective’ at the 2024 IMAP Independent Thought Conference in Melbourne.