By Witold Bahrke, senior macro and allocation strategist at Global Evolution
The Iran war highlights how a regime shift from a lack of demand to a lack of supply undermined the diversification edge of developed market government (core) bonds.
Once considered the undisputed backbone of the classic 60/40 investment portfolio, core government bonds now find themselves under a previously unthinkable level of scrutiny. Traditionally, when equities took a hit, core bonds would be there to pick up the pieces, making them the ideal defensive asset.
Yet in the wake of the Iran conflict, unlike with previous risk-off episodes, both risk assets and developed market government bonds nosedived together. The same defensive mechanism that once reliably stabilised portfolios now appears to be malfunctioning.
Many commentators point to the Iran conflict as the primary cause of this malfunction. An unexpected negative shock to oil supply has created significant upside risks to near-term inflation, pushing shorter-dated bond yields higher. At the same time, fiscal outlooks have deteriorated, fuelled by floundering growth projections and soaring energy costs, pushing up long-term yields. While this is sound analysis, it does not tell the full story.
See also: How incremental gains can help fixed income investors win consistently
The closure of the Strait of Hormuz and the subsequent energy supply shock is not the rare ‘black swan’ event it might first appear. What were previously once-in-a-generation negative supply shocks event is now happening with increasing frequency (the pandemic, the Ukraine invasion, and now the Iran war, to name but a few).
A barrage of negative supply shocks led to a deteriorating growth/inflation trade-off, forcing developed market central banks to abandon their pre-pandemic easing bias. In extension, this undermines central bank’s ability to support markets, resulting in shorter market cycles.
The average market cycle, defined as the time span between equity corrections, has almost halved since the pandemic. In other words, the market environment has become more tactical with frequent ups and downs in risk appetite. Yet markets have seemingly failed to adapt to this new reality.
While the increasingly unpredictable state of geopolitics has certainly contributed to this rapid turnover in market cycles, there is a far more concerning and deeper-rooted driver: the rise of inflation uncertainty, rooted in developed markets. It is becoming clearer each day that the post-global financial crisis “low-flation” era is over.
A number of factors, including changing patterns of globalisation, newfound fiscal largesse, and evolving demographics, have all contributed to the curtain closing on what was a good run. The common denominator is that the structural lack of demand between the great financial crisis and the pandemic has been succeeded by a structural lack of supply. Hence, the uncomforting truth is that investors are no longer enjoying the monetary tailwinds of a disinflationary pre-pandemic world. Instead, they are grappling with a new reality of higher inflation uncertainty. So, amid a barrage of negative supply shocks fuelling inflation risks, risk-off phases tend to go hand in hand with rising inflation.
In a macro regime shaped by a less market friendly mix between growth and inflation, core bond prices increasingly move in the same direction as risk assets. As a result, the cushion that core bonds once provided is wearing thin and their safe haven appeal is increasingly put into question.
See also: Dynamic Planner’s Chatterjee: Bonds are the new alpha
Amid the murkiness created by a market environment with shorter cycles, greater volatility and persistent inflation worries, one message has emerged with absolute clarity: diversification has never been more important. While the effectiveness of core bonds as a diversifier may be dwindling, opportunities still exist across a variety of asset classes.
The challenge for investors now lies as much in reallocating their mindset as their assets. This begins with re-evaluating long-held beliefs about the risk–return profile of investments outside the realm of traditional core portfolio segments.
For example, contrary to conventional wisdom, EM central banks reacted with far greater speed and ferocity to the post-pandemic inflation spike. The reward: EM inflation has returned to its pre-pandemic trend, while developed market inflation remains considerably above. Markets took note as the volatility pick-up in EM bonds relative to core bonds has shrunk. In this case, bonds that would once have been viewed as a risky satellite allocation, now look more like the pillars of a well-diversified cross-asset portfolio.
Investors who successfully adapt to this new regime will embrace a more open-minded approach, characterised by greater flexibility and a willingness to consider more unconventional assets. Much like the stages of grief, the final step is acceptance.
The macro environment and market dynamics as we once knew them are gone, and the time is ripe to rewrite the old bond playbook.
