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In an environment of rising interest rates the outlook for bonds is challenging. But as the cycle matures, bonds will play an increasingly important role in a well- diversified portfolio to help protect on the downside.
This article is from our latest edition of MarketWatch, an in-depth report focusing on the Global Economic Outlook for 2018.
It has been well documented that the outlook for fixed income assets and cash deposits remains challenging in the current low interest rate environment. Indeed for the last few years, government bonds have delivered little or no return as investors preferred to put their money into higher growing assets like equities and property.
As we start 2018, yields remain compressed relative to their historical averages across the entire fixed income spectrum. However, slowly but surely, central banks are starting to withdraw liquidity. In time this should lead to higher yields. In the US the Federal Reserve (Fed) has already raised rates four times and has signalled that they intend to shrink their balance sheet – after nine years and USD 4.5 trillion of bond purchases later. Even in Europe we are starting to see a move towards normalisation with the announcement of Quantitative Easing (QE) tapering by the European Central Bank (ECB), paving the way for the first rate hike in 2019.
Despite the low yields available, we think bonds will continue to be an important cornerstone of a well-diversified portfolio. Why? As we have seen time and time again, it is when things look best that investors often become complacent at the very time when they should be exercising caution.
We think this cycle is no different and there are already some signs of complacency in the equity market.
Bonds effectively act as an insurance contract within a portfolio – no other asset class offers the same level of protection when equity markets sell off dramatically. This is all the more important the further we progress in the cycle, particularly against a backdrop of high asset valuations and low volatility.
To illustrate the point it might be useful to remember what happened during the financial crisis. Figure 1 shows the performance of the S&P 500, the EuroStoxx 50, US Treasuries and eurozone government bonds in 2008 when the impact of the global financial crisis struck markets hardest. During this turbulent period the S&P 500 was down 38% over the year, while US Treasuries were up 14%. Similarly, the EuroStoxx 50 index was down 44%, while Eurozone government bonds were up 9%.
The lesson? The later in the cycle we get, the greater the risk of a downturn or bear market. Diversification is a golden rule of investing. Being overexposed to any one asset no matter how good it looks, can have a material impact on your portfolio. While the backdrop for equities has been very strong in recent years, the later in the cycle we get, the more investors might be well served to think of bonds more as a portfolio insurance rather than a driver of returns.