In this article for IG, Hoshang Daroga, CFA, Investment Director at Elston Consulting, explores whether and how to add back bond exposure.
Read in full [3 min read, open as pdf]
[5 min read, open as pdf]
The thirty-year anniversary of Black Wednesday was marked by the Sterling reaching its lowest levels against the dollar since 1985. Part of this is a function of dollar strength against global currencies, another part about rising concerns on the UK economic outlook and future policy-making. Sterling’s weakness and outlook is forcing investors to consider how to manage currency risk in their portfolio across each asset class. Full article available as pdf [5 min read, open as pdf]
With low growth, soaring inflation and spiking interest rates, advisers need to rethink the definition of risk. Focus on volatility is focus on the “wrong problem”. Instead, advisers should focus on preserving purchasing power (mitigate inflation risk) to protect client outcomes. That requires a fundamental rethink around traditional definitions of risk, asset allocation and diversification. For full article including charts, open as pdf [3 min read, open as pdf]
Latest UK inflation figure The latest UK inflation came in at 10.1%yy for June 2022, compared to 9.3%yy survey estimate. This is up from 9.4%yy last month and is above expectations. This is the highest UK inflation rate in 40 years, and now in double digits. Food prices rose meaningfully, especially bakery products, dairy, meat and vegetables, and this was also reflected in higher takeaway-food prices. Inflation pressure has not yet peaked with Bank of England expecting 13% in 4q22 (from 11%) and a further step-up in the retail energy price cap. The BoE remains behind the curve, in our view. See full article including all charts [3 min read, open as pdf]
Latest US inflation figures The latest US inflation came in at 8.5%yy for July 2022, lower than survey estimate. This is down from 40-year high of 9.1%yy last month and is lower than expectations of 8.7%. Gasoline prices fell by 7.7% in July, compared to an increase of 11.2%yy in June 2022. Food prices continued rising at a fast rate of 10.9%yy. Shelter cost moved higher by 0.5% from last month and went up by 5.7% from the same time last year. Read in full including charts [3 min read, open as pdf]
On 4th August, the Bank of England raised rates by 0.5%, the largest single increase since 1995. This followed the US Federal Reserve raising rates by 0.75% at the end of July. While these rate rises may or may not bring inflation under control, the risk they pose to growth is considerable. We consider the ways in which investors can use ETFs to build defensive resilience as an alternative to low-yielding cash or bonds. [3 min read, open as pdf]
What is the yield curve and how does it illustrate future expectations for the economy? In this article, we explain how to read the yield curve and discuss what the current version is suggesting in terms of inflation, interest rates and recession. With inflation at current levels, nominal bonds will remain under pressure. We explore the more resilient alternatives within the bonds universe as well as property, infrastructure, liquid real assets and targeted absolute return funds.
For full article, see Trustnet. [5 min read, open as pdf]
Read full article with charts [5 min read, open as pdf]
Inflation hits 40 year high UK inflation figures came out today with a print of +9.0%yy (April), from +7.0% (March) and slightly below +9.1%yy consensus estimate. This is the highest level in 40 years, putting renewed focus on the “cost of living crisis”. Rising energy and food costs are the primary drivers, linked to the sanctions regime and the Russia/Ukraine war. The Bank of England has been “behind the curve” as regards to inflation risk. A look at inflation guidance contained in recent Monetary Policy Committee (MPC) minutes shows. Near-term inflation guidance has consistently under-estimated inflation since August 2021 – rising from “above 2%”, to 4%, 6%, 8%,, 9% and now 10%. Read full article with charts [5 min read, full article in pdf]
In theory, through 2021 we have argued that bonds would remain under pressure against the twin pressures of rising interest rates and rising inflation. In practice, market dislocations of 1q22 evidenced this as bonds provide no place to hide in a time of market stress, and lost both their diversification and their protection characteristics. Indeed, the losses sustained on the bond side of a traditional multi-asset equity/bond portfolio were more extreme than the losses sustained on the equity side. The pressure on bonds will continue so long as we are in an inflationary regime. And that may be for the medium-term (e.g. 5 or more years based on market implied inflation rates). This is forcing a rethink for advisers reliant on equity/bond multi-asset funds to deliver a core investment strategy for their clients. [Read full article in pdf] Find out more about our Liquid Real Assets index strategy [5 min read, open as pdf for full article]
Equity markets endured a triple shock in the first quarter of 2022: a dramatic steepening of the likely path of interests, multi-year high inflation levels and a horrific war unleased in Ukraine. The traditional rational for including nominal bonds was to provide steady income, lower but positive returns, and diversification – a place of safety in periods of market stress. In face of rising inflation and rising interest rates, nominal bonds are providing none of these portfolio functions. Indeed in 1q22 not a single bond exposure delivered positive returns, and over 12 months only inflation-linked exposures delivered positive returns. Open as pdf for full article CPD Webinar Alternatives to Bonds in a Portfolio [5 min read, open as pdf]
In a recent CPD webinar, Elston’s Henry Cobbe interviewed Patrick Minford, Professor of Applied Economics at Cardiff University and economic adviser to Margaret Thatcher in the late 1970s and early 1980s to ask about the fight with inflation in the 1970s and any comparisons for today. While it is tempting to look for similarities with the energy shock and period of sustained inflation that the UK suffered in the late 1970s and early 1980s, Professor Minford highlighted some significant differences. The lower risk of a wage-price spiral, central bank independence and a track record of manging inflation means lower risk of inflation getting out of control in the long-term. But the short- to medium-term remains under pressure. In Minford’s opinion, the risk to the growth is the bigger risk: and this would be the right time for HM Treasury to worry less about debt ratios, and turn on Government spending taps. Read full article, open as pdf Watch the CPD webinar (50mins) [5 min read, open as pdf]
Rising inflation and rising interest rates, means nominal bonds (such as corporate bonds, UK gilts, and global government bonds) are under pressure, and will remain so for the medium-term. For so long as real yields remain negative, bonds are “guaranteed” to lose capital value in real terms over time. So what are the Alternatives to Bonds in a portfolio for UK investors? We explore the options within this article open as pdf or full version [5 min read, open as pdf]
In our 2022 outlook, we explained why inflation will remain hotter for longer and will settle above pre-pandemic levels. Advisers should consider how to adapt portfolios for inflation across each asset class – equities, bonds and alternatives. Research demonstrates how different asset classes exhibit different degrees of inflation protection over different time-frames. Equities therefore provide a long-term inflation hedge.
In this article, we explore how to adapt portfolios for inflation within and across each asset class: Equities, Bonds and Alternatives. For full article, read as pdf [3 min read, open as pdf]
2021 in review Our 2021 market roundup summarises another strong year for markets in almost all asset classes except for Bonds which remain under pressure as interest rates are expected to rise and inflation ticks up. Listed private equity (shares in private equity managers) performed best at +43.08%yy in GBP terms. US was the best performing region at +30.06%. Real asset exposures, such as Water, Commodities and Timber continued to rally in face of rising inflation risk, returning +32.81%, +28.22% and +17.66% respectively. 2022 outlook We are continuing in this “curiouser, through-the-looking glass” world. Traditionally you bought bonds for income, and equity for risk. Now it’s the other way round. Only equities provide income yields that have the potential to keep ahead of inflation. Bonds carry increasing risk of loss in real terms as inflation and interest rates rise. Real yields, which are bond yields less the inflation rate, are negative making traditional Bonds which aren’t linked to inflation highly unattractive. Bonds that are linked to inflation are highly sensitive to rising interest rates (called duration risk), so are not attractive either. How to navigate markets in this context? The big three themes for the year ahead are, in our view:
See full report in pdf Attend our 2022 Outlook webinar [5 min read, open as pdf]
Interest rates expected to rise As the run up in inflation looks more persistent, than transitory, there is growing likelihood that Central Banks will raise interest rates in response. Following an extended “lower for longer” near-Zero Interest Rate Policy following the 2008 Global Financial Crisis and the 2020 COVID Crisis, the market futures-implied expectations for the Fed Funds rate, points to a “take off” in 2022 in response to rising inflation, following COVID-related policy support, to an expected 1.01% interest rate level in Dec-23[1], from 0.88% last quarter. Fig.1. Fed Funds Rate and implied expectations Source: Elston research, Bloomberg data
The potential for increased interest rate volatility, as rate hike expectations increase, means that investors that are seeking to dampen interest rate sensitivity (“duration”) are allocating to shorter-duration exposures, such as ultrashort-duration bonds, and also to Floating Rate Notes (FRNs). What is a Floating Rate Note? Floating Rate Notes receive interest payments that are directly linked to changes in near-term interest rates and can therefore provide a degree of protection against interest rate risk, when interest rates are rising. Issued for the most part by corporations, FRNs pay a periodic coupon – typically quarterly – that resets periodically in line with short-term interest rates. This could be expressed as a premium or “spread” over a currency’s short-term risk-free rate, such as (in the UK) the 3 month SONIA rate (Sterling Overnight Index Average, and prior to that GBP LIBOR) in the UK, or (in the US) the 3 month SOFR (Secured Overnight Funding Rate, and prior to that USD LIBOR). These indices overnight borrowing rates between financial institutions. The size of the premium or spread reflects the creditworthiness of the issuer: the higher the spread, the greater the rewarded risk for owning that security, and typically stays the same for the life of the bond and is based on the issuer’s credit risk as deemed by the market. How can FRNs benefit investors? Floating Rate Notes are a lower-risk way of putting cash to work and provide a useful direct hedge against interest rate fluctuations. When incorporated into a bond portfolio, they can help bring down duration given their reduced sensitivity to interest rate changes, as well as provide a return pattern that is directly and positively correlated with changes in interest rates. Compared to nominal bonds, such as Corporate Bonds and UK Gilts, FRNs’ yield can increase as/when interest rates increase. Relative to money market funds, FRNs may provide some additional yield pick-up, as well as very short <1 year duration. Key considerations when investing in FRNs Portfolio investors can access FRNs through funds and ETFs. Key considerations when investing in FRNs include, but are not limited to:
Summary The expected timing of interest rate “lift off” in the US and UK will change as markets adapt to evolving growth and inflation outlook during the post-COVID recovery, and in response to the risk of further disruption from new virus variants. However, as interest rate rises become more likely, and incorporating an allocation to Floating Rate Notes for protection against interest rate risk makes sense within the bond allocation. Watch the CPD Webinar: The Quest for Yield [1] Data as at last quarter end Register for the webinar/View the replay Read the full article
What is the 60/40 portfolio? Trying to find the very first mention of a 60/40 portfolio is a challenge, but it links back to Markowitz Modern Portfolio Theory and was for many years seen as close to the optimal allocation between [US] equities and [US] bonds. Harry Markowitz himself when considering a “heuristic” rule of thumb talked of a 50/50 portfolio. But the notional 60/40 equity/bond portfolio has been a long-standing proxy for a balanced mandate, combining higher-risk-return growth assets with lower-risk-return income-generating assets. What’s in a 60/40? Obviously the nature of the equity and the nature of the bonds depend on the investor. US investors look at 60% US equities/40% US treasuries. Global investors might look at 60% Global Equities/40% Global Bonds. For UK investors – and our Elston 60/40 GBP Index – we look at 60% predominantly Global Equities and 40% predominantly UK bonds Why does it matter? In the same way as a Global Equities index is a useful benchmark for a “do-nothing” stock picker, the 60/40 portfolio is a useful benchmark for a “do-nothing” multi-asset investor. Multi-asset investors, with all their detailed decision making around asset allocation, risk management, hedging overlays and implementation options either do better than, or worse than this straightforward “do-nothing” approach of a regularly rebalanced 60/40 portfolio. Indeed – its simplicity is part of its appeal that enables investors to access a simple multi-asset strategy at low cost. The problem with bonds (the ‘40’) in an inflationary environment Over the years, the relationship between asset classes has changed so much that the validity of 60/40 as a strategy can legitimately be questioned. Read the full article or register for the webinar/View the replay [Open as pdf]
Money market funds, and their exchange-traded equivalents “ultra-short duration bond funds”, are an important, if unglamorous, tool in portfolio manager’s toolkit. They can be used in place of a cash holding for additional yield, without compromising on risk, liquidity or cost. Money market funds are intended to preserve capital and provide returns similar to those available on the wholesale money markets (e.g. the SONIA rate that replace LIBOR). How risky is a money market fund? Money market-type funds hold near-to maturity investment grade paper. Their weighted average term to maturity is <1 year. They therefore have very low effective duration (the sensitivity to changes in interest rates). Compare gilts which are seen as a low-risk asset relative to equities. The 10-11 year duration on UK gilts (all maturities) means they carry a higher level volatility compared to cash (which has nil volatility). On the flip side, their longer term also means they have higher risk-return potential relative to cash and ultra-short bonds. By contrast, money market type funds have some investment risk as they hold non-cash assets, but given their holdings’ investment grade status, short term to maturity and ultra-short effective duration, they exhibit near-nil volatility. Platform cash, fixed term deposit or money market fund From a flexibility perspective and a value for money perspective, there's a clear rationale to hold money market funds, rather than platform cash or a fixed term deposit. Our Money Markets fund research paper that looks at 4 low cost money market funds sets out why Why does the fund structure make sense? Find out more in our CPD Webinar on Introduction to Collective Investment Schemes |
ELSTON RESEARCHinsights inform solutions Categories
All
Archives
June 2024
|