Prospect of higher inflation turns investors bearish on fixed income funds
Fixed income funds enjoyed a good year in 2020, with strong investment flows from investors seeking safety in central bank-supported bonds, as the pandemic ripped apart stock markets.
In the last quarter alone, institutional investors poured USD177.6 billion into fixed income strategies, according to eVestment data. In the same period, they withdrew USD117.4 billion from active US equities.
But the tide has turned in 2021, with growing expectations of higher inflation driving a sell-off in government bonds, which has begun to spill over into equity markets.
Investors are increasingly expecting a rise in inflation to follow a successful roll-out of vaccines and an economic rebound, especially with assurances from central banks that they will continue to pump liquidity into markets with loose monetary policy and by buying bonds.
Fund managers are cutting their allocations to bonds and embracing risk assets again, with optimism towards global equities at its highest level in 10 years, according to a monthly survey from Bank of America in February.
Net bond allocations have fallen by 3 percentage points since January, with 62 per cent of managers saying they are now underweight bonds.
Momentum is “clearly bearish” for fixed income in the coming weeks and months, says Anthony Carter, fixed income manager at Sarasin & Partners.
After strong inflows to fixed income strategies, especially credit, in the second and third quarters of 2020, Carter says this “slowed to a trickle” in Q4 and even led to some outflows at the turn of the year due to low rates and tight spreads.
“Now spreads are still tight but rates are rising so the all-in yield on credit has improved, so we are back to seeing a trickle of inflows,” says Carter.
Carter believes the drawdown in fixed income year-to-date, roughly 3 per cent in US broad fixed income, “represents the bulk of the losses likely to be inflicted on fixed income” and that ultimately returns will be “modestly positive” for the rest of the year.
“There will be opportunities for active managers to make considerably more than that, however, by targeting areas with greater return possibilities, like subordinated financial paper or some areas of emerging markets,” says Carter.
For government bonds, prices are falling and yields are rising, with 10-year US Treasury yields hitting 1.48 per cent on Thursday.
While Sarasin & Partners still prefers investment grade corporate debt, Carter says that government bonds are starting to look appealing due to lower valuations, adding that current inflation expectations may be overstated.
According to Bank of America’s survey, 86 per cent of fund managers expect higher inflation in the next 12 months.
“Ultimately, we see no case for the multi-decade trend to lower inflation to be arrested in the long-term. Indeed, from a bottom-up perspective we can see certain areas of the economy where disinflation is likely to accelerate, such as transport (business travel highly unlikely to return to pre-pandemic levels), retail (even greater online share vs high street), or entertainment (greater trend to new releases being streamed at home rather than viewed in a cinema),” says Carter.
In the short term, yields may continue to rise based on a bearish bond market and a cyclical uplift in inflation over the next few months, although “that will start to subside again by mid-year”.
“To be honest, bond yields should not really be taking their lead from short-term inflation dynamics – but right now the market is casting around for reasons to be bearish rates, and inflation is one of the rationales offered up,” says Carter.
Andrew Lake, head of fixed income at Mirabaud Asset Management, doubts that inflation will rise for good anytime soon, with “still high unemployment, and a recovering but damaged economic environment”. Nevertheless, he says the debate over inflationary pressures is “not going away in the short term”.
“The bottom line is that there will be no move higher in interest rates this year (as distinct from government bond yields) and equally there will be no withdrawal of underlying fiscal or monetary support,” says Lake.
The Reserve Bank of Australia restarted its bond purchases this week in order to stop its government bond yields rising any higher, and the US Federal Reserve has also pledged to continue its bond-buying programme to support markets.
“We would need to see economies on a permanent and sustained road to recovery, an end to the pandemic, and a recovery in employment. Whilst we could see an acceleration of re-employment if quick re-opening happens, given that much of the unemployment has been in hospitality, it is still going to take time,” says Lake.
On Tuesday, Fed chair Jerome Powell warned in his monetary policy update that the country’s economic recovery is “uneven and far from complete”.
Investors piling into commodities is increasing the “perception of inflation”, as they are often used as a hedge against inflation, says Lake. Prices surged this week with the Bloomberg Commodity Spot Index reaching its highest level in eight years.
“It feels like we should have a pull-back, but re-opening optimism continues to be the focus so far,” he says.
Meanwhile, higher bond yields have implications for equity markets, says Lake.
Investors are encouraged to buy equities and corporate bonds when government bonds offer low rates, because they are seen to offer better returns than owning government debt.
“The real concern will be whether yields move high enough to snuff out any further equity market rally and indeed the nascent economic recovery from here,” says Lake.
Equity markets came off record highs in February, with the S&P 500 and Nasdaq both falling by around 2 per cent in the past day of trading.