HUB EXCLUSIVES PANEL DISCUSSION 2022 – GOVERNMENT BONDS: A RETURN TO NORMAL?
Panel discussion, hosted by Cherry Reynard, with:
Adam Darling – Investment Manager, Jupiter Asset Management
Andrew Eve – Investment Specialis, M&G Investments
Simon Prior – Fund Manager, Premier Miton Investors
The decade-long bull market in government bonds came to an abrupt halt in 2023. Inflation revived, as the war in Ukraine and supply chain constraints pushed up energy and food prices, with interest rates rising in response. The resulting slump in government bond prices has been painful for investors. However, with yields at their highest level since 2010, could they hold more appeal in the year ahead?
Structurally deflationary factors operating over many decades have helped keep inflation low: technology has reduced costs and increased price discovery among consumers, while globalisation and access to cheaper labour have pushed production costs lower. At the same time, baby boomers moving into retirement has created demand for government bonds. These factors, along with central bank buying from quantitative easing, have driven a multi-decade bull market for government bonds. In 2022, inflation came back with a bang, globalisation began to unwind, labour pressures start to emerge and central banks reversed course.
The question now is whether that adjustment has been made in full. Interest rates are likely to continue to rise in 2023, but this is largely priced into markets. Inflationary pressures appear to be ebbing, but global bond markets must also absorb the effect of quantitative tightening. Yields are high, but the risks are still finely balanced for the asset class.
Duration
Fixed income fund managers are tentatively starting to re-embrace duration in their portfolios. Andrew Eve, fixed income investment specialist at M&G, says: “Central banks will drive the market. They are likely to taper the pace of interest rate hikes. While there may be some small increase in yields at the start of next year, there will be a moment to start to add to interest rate duration.”
Adam Darling, investment manager, fixed income, Jupiter Asset Management, says their team has been incrementally adding duration as it has built conviction that inflationary pressures are turning. He says: “We view the duration as a hedge to the recessionary risk. We’re not all-in bullish just yet, Inflation could be stickier for a while, and there are economic and political risks. That said, a 4% yield on treasuries and gilts means investors are better compensated than they have been for some time.”
Simon Prior, fund manager, fixed income team at Premier Miton Investors says quantitative tightening could be a pressure on the market. So far, it has lived up to the Fed’s view that it would be as “boring as watching paint dry”. However, he adds: “There is quantitative tightening, plus monetary tightening. There is a danger there will be a hard landing for the economy, plus persistent inflation, creating a stagflationary environment. This is no good for any asset class.”’
At the moment, he says, the consensus is for a shallow recession. However, a deeper recession may be needed to push the labour market into a better balance. He adds: "Fixed income does well when the economies are chugging along. If the economy is doing very well, investors are better off in equities. It is possible that the global economy could have a soft landing and ‘chug along’. That may be good for risk assets and for bonds.”
Back to normal
Bonds’ traditional role in a portfolio has been as a source of income, diversification against equity market volatility and a source of capital protection. However, that has broken down in recent years with bonds and equities increasingly correlated. In 2022, government bonds provided no protection for investors against equity market weakness.
However, there is a chance that they can fulfil this role once again. Prior says: “We should never forget that government bonds are the bedrock of capitalism, everything else is priced from them. They are still the risk-free asset. They are the default safety asset if we go into a difficult environment.” With inflationary pressures falling and yields higher, the diversification and capital preservation elements of government bonds can revive.
If the world is going into an environment where a lot of the tightening has already been done and a combination of interest rises and quantitative tightening slow the global economy and bring inflation down then there is likely to be more enthusiasm for government bonds, says Prior. “We’re unlikely to see the ups and downs of the past few years. I wouldn’t build an investment case that government bonds would go back to 0.5%. We hold them because they provide diversification and ballast going into a more uncertain economic environment.”
