This article is part of Morningstar's "Perspectives" series, written by third-party contributors. Here, Nick Gartside, international chief investment officer for Fixed Income, J.P. Morgan Asset Management debates the great un-rotation.
The popular investment narrative of market pundits for 2014 was to be overweight equities. Thus far, things have not gone according to plan. In fact, bonds have actually done better than stocks since the start of the year. This was supposed to be a bad time for bonds, but you would be hard-pressed to find any signs of a panic trade. It may be early days, but if this persists, we may be looking at the great “unrotation” rather than the “great rotation” that so many speculators had predicted.
It's been a very good start to what is admittedly a very short year
There are a few reasons for this, some of them basic. One is that investors need bonds to anchor their portfolio. People own bonds because they provide an income.
Remember the critical difference between a bond and a stock. With a bond, you are lending money and the company has an obligation to repay you. With a stock, you are buying a share of future profits. The latter is a much riskier bet.
So this need for income is one part of the bond story. The other part is diversification. If equities come under pressure, you naturally should expect government bonds to do better by comparison. A balanced portfolio means you're never left in a circumstance where all of your assets are going in the same direction at once.
Bond investors essentially have two enemies: one is rising interest rates, the other is inflation. Watching over your shoulder for those enemies should be on the checklist of anyone in receipt of a fixed income.
So how does the dashboard look? The potential for rising interest rates is, of course, inevitable, but we think any action is later rather than soon. Thankfully, the U.S. economy is growing at a stronger rate than it has in the years since the financial crisis, but gross domestic product is still well below trend compared to past economic recoveries. Meanwhile, inflation is benign.
Inflation is determined by both external and internal factors. On the first of these, developed economies are now the price takers, as opposed to setters, of commodity prices, and with emerging economies slowing, the marginal buyer of commodities such as food and fuel has stepped away, resulting in lower inflationary pressures for developed economies. The key to internal inflation remains wage growth. Or, more precisely, the lack of wage growth. The harsh reality is that American workers continue to receive wage increases barely in line with inflation. In an economy where consumers represent around two-thirds of GDP, the absence of meaningful wage increases means inflation is likely to remain muted. So there are two enemies relegated to the sidelines for now.
Now, the practical question you have to ask as a bond investor is perhaps the most important: What type of bond? After all, the risks and opportunities in the spectrum vary widely. The reality is that bond markets have changed and with that, a paradigm shift among bond investors has gotten under way. The challenge to find attractive returns among the bond pitfalls of recent years has caused a sea change toward flexible “multisector” approaches.
This means looking across the global opportunity set, divorced from traditional bond benchmarks. By their nature, bond benchmarks reward bad-behaving borrowers by giving the greatest weight to the most indebted. They are also sensitive to interest rate risk because of their duration, which is not a risk that today's bond investor should be carrying, in our view. In what is an increasingly fragmented and idiosyncratic bond market, taking a global unconstrained approach to finding the best investments ideas is important.
So what in the global opportunity set looks promising? Arguably, government bonds don't look very attractive, although they have benefited very recently from the turmoil in risk assets and emerging markets. More interesting prospects are in corporate bonds, both investment-grade and high-yield, which offer better reward in the form of yield for the risk you're undertaking in owning them against a backdrop of gradually improving growth, low default rates and corporate balance sheets in good health.
We’ve kept headline duration low to protect against rising interest rates, primarily by shorting government futures. Our optimism about the global economic recovery is restrained by the potential for deflation in Europe, as well as widespread sub-trend growth in emerging markets. Given that background, government bond yields should continue to rise and investor appetite for spread product is likely to remain robust. We see pockets of value in bank hybrid securities for issuers with strong or improving credit fundamentals, and in non-agency securities, which are benefiting from the recovery in property prices. Elsewhere, emerging markets remain under pressure and we are closely watching for attractive entry points to accumulate both local bonds and currencies.
For global bonds, it's been a very good start to what is admittedly a very short year. It may be early days, but we think there is life in the old bond dog yet. Investors would do well to remember that and look beyond the convenient market narratives.
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