The growth bias among financial assets of the last decade has become entrenched in equity indices. Simultaneously, bonds seemingly shed their protective qualities, offering investors very little by way of diversification.
This came to a head in 2022. Last year played host to one of the worst bond market sell-offs in a generation after central banks aggressively raised interest rates to contain inflation. Bonds and equities fell in tandem, bringing into question the merits of bonds altogether as a diversifying asset class in a traditional 60/40 portfolio.
It is largely for this reason that, until recently, we had very little exposure to bonds in our multi-asset portfolios. But the outlook for the asset class has changed. We now see bonds offering higher yields and providing better diversification as part of a multi-asset portfolio. We’ve even gone so far as to herald the "re-birth" of the 60/40 portfolio when some still believe it is dead.
In this changed environment, we see attractive opportunities to make decent returns in the bond market. The pivotal factor remains central bank policy and how far interest rates will have to rise to bring inflation back down. Given the pace of rate rises to date, it may well be that policymakers push too far, creating a slower economy than perhaps people will be expecting and with it, a slowdown in consumer spending.
The Real-World Lag
Expectations at the end of 2022 centred around one word for 2023: recessions. It's been said it typically takes nine to 12 months for interest rate changes to feed into the real economy, but we think it may take longer. In the U.K and Canada, many homeowners had moved onto five-year fixed rate mortgage terms and taken advantage of lower interest rates. It may therefore take longer to see higher interest rates affect consumer spending.
It could take even longer to play out in the US, where 30-year fixed rate terms are the dominant mortgage product, protecting disposable income for people with these long-dated loans. In addition, older people typically don't have mortgages and benefit from higher interest rates on their savings, which boosts their spending power overall.
Further, the combination of real wage strength – keeping pace with inflation – and high household savings have meant a lag in the true effects of higher interest rates on the real economy. The real-world impact of monetary tightening isn’t quite biting yet, though we expect to see these effects starting to take hold by the end of this year.
Better Diversification
At the point at which the economy does eventually roll over it could create an environment in which equities struggle.
In this scenario we think government bonds should offer better diversification, particularly in relation to their plight in 2022. As such, the Newton mixed assets team has gradually increased its weighting to government bonds and to a lesser extent, corporate bonds. We have also reduced our alternatives exposure, reallocating resources up the capital structure in the bond market given their attractiveness as an income-producing investment.
Overall, we believe bonds are worth buying again, both in terms of their potential to generate returns and for diversification purposes. In our view, they should once again play a bigger role in a well-diversified portfolio; one that also keeps exposure to growth opportunities within equity markets and to real assets that can provide an attractive level of yield in the inflationary environment.
Paul Flood is head of mixed assets investment at Newton Investment Management. Newton is a global investment management firm, owned by BNY Mellon.
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