David Jane, fund manager, Premier Miton Macro Thematic Multi Asset Team, Premier Miton Investors, discusses how a changed inflationary environment affects the approach the firm is taking to asset allocation and, in particular, to the use of bonds in portfolios.
We are strongly of the view that the market regime changed in 2020, with the end of the disinflationary era and the re-emergence of inflation as a factor. Portfolio managers need to take this into account.
The fact that we have exited the extended period of disinflation is fundamental to markets and portfolio construction. Disinflation created the anomalous effect that equities and bonds became negatively correlated for an extended period. This should not be the case, all assets are priced off the ‘risk free’ rate – the bond yield. So positive correlation should be the norm. The period post 2000 was unusual in the fact that inflation was consistently low and falling. Periods of weak growth were associated with aggressive rate cuts, hence the negative correlation. This was exacerbated as we entered the QE period post the general financial crisis (GFC).
We are now back in a period of more normal inflation and growth, indeed inflation remains above most central banks’ target levels, despite the expectation of rate cuts in the near term. As we have seen, equities have been strong as inflation expectations have come down, alongside stronger bond markets.
We think most investors believe we will revert to the old post-GFC environment, or, at a minimum, bonds will rise in equity bear markets. As a consequence most still believe duration will diversify equity exposure, or at least act as if it will.
Different approach to asset allocation
This new environment requires a different approach to asset allocation. A blend of equities with long dated bonds, might be successful in periods like the last six months, but if inflation reasserts it will be as bad as it was in 2022. This approach to allocation is a recipe for highly volatile returns. To reduce volatility we can use shorter dated bonds, which will return their yield to maturity with much lower risk.
Having seen a strong rally, as inflation expectations have reduced near term, it pays to ask what bonds should yield here. The text books would suggest that, for example, US ten year bonds, should reflect the markets expectation of nominal economic growth over the coming ten years – the opportunity cost of tying your money up for ten years. Whilst we can argue that point in the context of aggressive intervention and leverage, it provides a framework to get an idea of where they might be headed over the long term. It is reasonable to believe that intervention can only work up to a point at manipulating prices and indeed aggressive downward pressure on yields from market intervention can create the outcome of lower economic growth as has been seen in Japan.
Current US ten-year yields are 4%. That suggests the market expects 4% per annum nominal GDP growth over the next ten years. The working age population in the US is estimated to be growing at between 1.2% and 1.5%1. Productivity per worker might be expected to grow at something less than 1%2, which suggest the market expects inflation to fall back to close to 2% or less over the coming years.
Markets are pricing a reversion to the post GFC environment. Alternatively, they are pricing a period of economic contraction and/or further disinflation here. Simultaneously, equity markets appear to believe the soft landing scenario.
We think 2% inflation is implausible for all the reasons we have outlined before. More reasonable would be an expectation of 3% or above, in line with longer term history. In fact, our thesis is a period of relatively high inflation with a series of peaks over the coming years followed by falls. In that case, bond yields could be set for a resumption of their uptrend, particularly if the soft landing materialises, while inflation remains above target. Longer term we see yields averaging 5% or higher over the decade, potentially with periods where they go significantly higher than that.
That makes bonds a difficult asset class for investors to use as a diversifier for equities. The downside risk coincides with downside risk in equities. Periods of rising inflation will likely coincide with weaker equity markets. In those circumstances bonds will provide no diversification benefit, unless only short dated bonds are held. To diversify inflation, less interest rate sensitive real assets need to be held, such as commodities. Aggressively actively managing asset allocation can deal with this more volatile economic environment. Safer to hold a portfolio focussed on real assets, with short-term bonds as a cash proxy to reduce volatility if necessary.
1Organization for Economic Co-operation and Development, Working Age Population: Aged 15-64: All Persons for United States [LFWA64TTUSM647S], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/LFWA64TTUSM647S, January 11, 2024
2University of Groningen and University of California, Davis, Total Factor Productivity at Constant National Prices for United States [RTFPNAUSA632NRUG], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/RTFPNAUSA632NRUG, January 11, 2024.
