Partner Content: Alex Stanley from Ardea Investment Management suggests that investors have few places to hide amid a synchronised sell-off in both bonds and equities. However, there are catalysts that could ultimately drive renewed support for bond markets.
The historically poor performance of bonds has continued over the last few months. The 60bp increase in the US 10y yield in April was the largest monthly increase since 2009. Other markets, such as Europe, have seen similarly large moves. This sell-off builds on a horrible Q1 for bonds – the worst in over 30 years for some benchmarks. Year-to-date (as of 9 May), the Bloomberg Global Aggregate Bond Index is down 12%.
Bonds have not been a safe place to hide from weaker equity markets. After staging a brief rebound over the second half of March, equities slumped through April and early May. Year-to-date, major indices are down as much as 17%.
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Recent developments have focused market participants on this risk, notably:
- The most aggressive Fed tightening cycle since 1994, undermining confidence in a soft-landing for the US economy.
- A broadening of global central banks lifting rates.
- Prolonged surging inflation that continues to exceed forecasts and central bank targets.
- A slowdown and lockdown in China weighing on both the outlook for global growth and supply-side price pressures.
- The Ukraine war exacerbating commodity price pressures and risk of an energy crisis in Europe.
Many market participants have been burned by inflation forecasts, and now need to see hard evidence of a turn lower in inflation data before being convinced of improved value in bonds.
What could drive a turnaround in bonds?
In previous cycles, the peak in longer-term yields has typically occurred much further into the cycle. However, given the pace of the recent rise in bond yields, weaker stocks and some models and investor surveys pointing to rising recession risk, the peak in yields could be seen earlier this time around.
We have identified three key catalysts that could ultimately drive renewed support for bond markets.
- Inflation data pulse turns lower Bond yields could rise significantly until the inflation dynamics start to turn. The sheer magnitude of inflation pressure and forecast misses over the last year has shifted market psychology. Many market participants have been burned by inflation forecasts, and now need to see hard evidence of a turn lower in inflation data before being convinced of improved value in bonds.
- Risk asset correction deepens significantly A sharp enough correction in risk assets could drive flows back into bonds. Significant bear markets in equities tend to be seen when recession risks are nearer. On some basic measures, the equity correction of the last month is starting to price a significant downturn in growth, but picking the tipping point for bonds from weaker risk assets is tough while inflation is rising sharply.
- Higher yields become more appealing to investors Notwithstanding year-to-date volatility, in a multi-asset portfolio context, high-quality government bonds typically play a defensive role due to their lower-risk characteristics. There is usually a trade-off here because the lower-risk benefits come at the cost of lower returns. In recent years, this opportunity cost has been high because the ultra-low interest rate environment evaporated the returns available from defensive investments.
While the recent correction in bond markets drives capital losses, there has been substantial further flight out of bonds. However, the dial may start to turn soon as valuations now look more enticing. Yields are now at the highest levels in some markets for seven years or more and previously negative yielding markets such as Europe now offer positive yields.
Alex Stanley is relative value strategist at Ardea Investment Management.
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