Henry Peabody, Diversified Fixed Income Portfolio Manager, Eaton Vance says that “the ‘safest’ assets in the past may not be the safest in the future.”
The bond market is facing a particularly fascinating and complex environment today as decades of relationships and long-term trends are being questioned, he notes.
“Perhaps the most important evolving change is the shift from monetary to fiscal policy as a source of growth. The bond market seems to be anticipating this with interest rates rising sharply and causing investors to reassess expectations from and the role of fixed income in a portfolio.
“Owing to the dollar’s position as reserve currency, the U.S. has been able to consistently expand its balance sheet and lead global growth, while simultaneously lowering interest rates. This has provided bond investors with a generational tailwind of returns.
“Now, the U.S. finds itself with about $19 trillion of debt, Treasury yields that are still not far off their lows, a policy focus on growth and inflation, and a dollar that is in the upper end of its valuation range. This doesn’t seem sustainable, and if investors still see fixed income as an integral part of a portfolio, flexibility will be needed, and the role of traditional fixed income should be questioned. We believe this is an excellent environment for a flexible approach.
“For over three decades, investors have been conditioned to view bonds as reliable producers of not only income, but also capital gain that can help stabilize a portfolio of “riskier” asset such as stocks. Paradoxically, this portfolio hedge turned out to be a major driver of return. In fact, the Bloomberg Barclays US Aggregate Index has returned roughly 4.3% annualized over the last 10 years, which not far behind the 6.9% return for the S&P 500 Total Return Index. Bonds are seen as safe, especially those backed by the U.S. government, which prints the currency in which the debt is denominated.
However, the “safest” assets in the past may not be the safest in the future.
“Treasury yields have risen sharply as investors position for a Trump administration. They are expecting tax cuts, infrastructure spending, less regulation and protectionist policies with the potential for erosion of purchasing power. Further federal balance sheet expansion could continue to pressure rates higher in the long term. It looks like the Federal Reserve will have to walk a fine line between offsetting fiscal stimulus and encouraging further strength in the dollar.
Positioning for these changes will be very important for investors. Equally critical is a recognition that the world is as complex and tense a place as it has been in many investors’ lives. Political adjustment and geopolitics will contribute significantly to volatility.
As long-term investors, there is a great deal for us to think about. How will global powers align in a Trump presidency? What is the likely direction of the dollar? What will a growth platform look like under Trump and how likely is it to succeed? And, where does that leave attractive risk/return in fixed income? There are more questions than answers at this point, and the degree that the market is pricing in a certainty may be premature.
In an environment such as this, we believe a long-term view with an eye toward value will be well rewarded. The herd is often wrong – as it was when negative yielding bonds were looked at for return, while equities served as income generator. Many domestic traditional credit sectors are at or near their historical tights in spread or lows in yield, and for this reason represent unattractive risk/reward.
Developed market government yields still remain low, though U.S. Treasuries could benefit from continued global demand, such as from Japanese or European investors whose central banks are still easing. When growth and inflation are policy goals, and protectionism remains a risk, sectors that could benefit from an eventual turn lower in the dollar are attractive.
For this reason, we argue that flexibility will be exceptionally important. Finding companies and countries that offer value, often due to short-term behavioral or misunderstood fundamentals, is a way to capture higher expected return as well as cushion against rising rates. Presuming historical returns, or relationships, in such a period of transition is perilous.
So never has it been a better time to be an active manager in fixed income with the ability and flexibility to think a little bit differently than the crowd.
About Eaton Vance
Eaton Vance (NYSE:EV) is a leading global asset manager whose history dates to 1924. With offices in North America, Europe, Asia and Australia, Eaton Vance and its affiliates managed $334.4 billion in assets as of July 31, 2016, offering institutions and individuals a broad array of investment strategies and wealth management solutions. The Company’s long record of providing exemplary service, timely innovation and attractive returns through a variety of market conditions has made Eaton Vance the investment manager of choice for many of today’s most discerning investors.
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