Beyond bonds

Read this article to understand:

• The risks to inflation posed by renewed political uncertainty and loose fiscal policy
• Why bond volatility is likely to remain elevated
• Why there is an ongoing case for adding liquid alternatives to portfolios

Investors in traditional multi-asset funds had for some time come to rely on the ability of bonds to provide a steady source of ballast to their investment portfolios. That changed in 2022 when soaring inflation forced central banks into a dramatic tightening of monetary policy sending both equities and bonds down sharply in tandem.

While equities soon recovered, bonds took far longer to find a floor as central banks struggled to get inflation under control. But by the autumn of 2023, it appeared bonds had finally begun to stabilise. Amid growing expectations inflation had been slayed, the prospect of interest rate cuts led many investors to conclude yields had begun to look attractive.

Suddenly markets appear skittish again. Some of the nervousness is down to heightened political uncertainty, with Donald Trump’s recent US election victory highlighting the ongoing allure of populist politicians.

Turning on the taps

They are invariably courting dissatisfied electorates with the prospect of big spending commitments or tax cuts, with fiscal policy seemingly less of a priority. Even those who fail to gain power, can set the agenda, meaning governments of all persuasions have been opening the spigots.

Many governments had made some progress in bringing debt down after it ballooned due to huge emergency handouts during the pandemic. However, investors are starting to question whether governments are able, or even willing, to get borrowing under control.

As he did eight years ago, Trump is vowing to slash taxes. Although he is also promising to cut spending, few expect those savings will come close to offsetting the fiscal impact of the proposed tax cuts.

According to independent analysis by the Penn Wharton business school, the President-elect’s campaign tax and spending proposals would add $4.1 trillion to the primary deficit over the next decade.¹

A report by the non-partisan Congressional Budget Office (CBO) published in June, forecast US government debt was already on course to swell to a record 116 percent of GDP in 2034.²

Penn Wharton reckons Trump’s pledges, if enacted, will add ten percentage points to this figure.

Whereas governments used to operate fiscal policy in a counter-cyclical fashion to help smooth economic cycles, Trump is proposing to loosen fiscal policy at a time when the US economy is operating fairly close to full capacity.

Fiscal loosening threatens return of inflation 

That means any fiscal loosening would not only add to concern about the ever-expanding US deficit but would also likely be inflationary. Adding to the inflationary threat, Trump has vowed to impose large tariffs on imports from the rest of the world, and to deport a significant number of migrants.

The Treasury market was already having to absorb a lot of debt. It might be the world’s most important risk-free asset, but it is not immune to concern over the scale of fresh supply, especially in an environment of potentially higher inflation.

As seen in Figure 1, the US is not the only country where a deteriorating fiscal outlook has been among the factors weighing on bond prices. Yields on UK ten-year government bonds, having leapt by a percentage point in the past year, currently stand close to their highest point since before the financial crisis of 2008.

The UK government outlined plans to spend an extra £70 billion a year in its October budget and ease its self-imposed fiscal rules. Annual borrowing is expected to rise by £32 billion (one per cent of GDP) as a result.³ The budget is also expected to boost inflation.

While fiscal rules make it harder for euro zone nations to loosen the fiscal purse strings, here too several governments are struggling to keep borrowing under control in the face of sluggish economic growth and a deteriorating demographic situation.

Take France. The additional yield investors demand to own French government debt over its German equivalent soared to its highest level since the euro zone debt crisis of 2012 this summer as seen in Figure 2.

The sell-off was prompted by an unexpected deterioration in government finances, exacerbated by fears Marine Le Pen's eurosceptic National Rally could win power.

Her party had been calling for a lowering of the retirement age, cuts in energy prices, increased public spending and a protectionist "France first" economic policy.

Debt sustainability a concern

The European Central Bank said on November 20 the euro zone risked another debt crisis if the bloc failed to boost growth, lower public debt and fix “policy uncertainty”. In its annual Financial Stability Review, the central bank warned over a potential return of “market concerns over sovereign debt sustainability”.⁴

Less than a month before, the International Monetary Fund forecast global public debt was set to exceed $100 trillion by the end of the year, and approach 100 per cent of GDP by the end of the decade.⁵

The fund said major economies’ plans to stabilise borrowing “fall far short of what is needed”. However, the risk is that as political turbulence intensifies, politicians of all colours will avoid unpopular spending cuts and tax hikes and instead succumb to the path of least resistance and allow deficits to keep rising.

The CBO forecast rising deficits would cause federal debt to soar to 172 per cent of GDP by 2054.⁶ The experience of Japan, where government debt is more than 250 per cent of GDP, suggests there is minimal risk of a country such as the US defaulting, given the enduring strength of global demand for dollar-denominated assets.

But it should be remembered that Japan ran up its huge debt pile during a period of deflation. The Bank of Japan was able to soak up most of that debt without stoking inflation. With the US economy operating close to full capacity, the Federal Reserve is arguably in a quite different position.

Were unfunded tax cuts to reignite inflation, bond vigilantes could force yields appreciably higher notwithstanding the US Treasury market’s status as the world’s premier risk-free asset.

At the very least, it seems safe to assume ten-year US Treasury yields are not returning anywhere close to where they were in the decade or so prior to the spike in inflation in 2022. And bond market volatility, which has soared in recent years, as seen in Figure 3, seems set to stay at an elevated level.

Against this increasingly uncertain backdrop, bonds seem unlikely to provide as robust a hedge against equity market risk as they did for two decades or more prior to 2022. Worse still, from an investor’s point of view, there is a risk that should bond yields rise appreciably further this could puncture the equity market rally.

The ongoing need for diversification

Since 2022, a growing number of investors, both institutional and private individuals, have been turning to alternative investments as a potential source of higher yields, lower volatility and increased diversification. The uncertain outlook for leading government bond markets suggests this trend may persist, or even accelerate.

The beauty of global macro funds, such as our Aviva Investors Multi-Strategy Target Return (AIMS TR) strategy, is they provide access to return drivers that are unrelated to traditional risk premia. While varied in style, macro funds are typically unconstrained, in contrast to traditional funds that are benchmarked.

Their ability to go long and short, and to access instruments that more precisely track inflation and other investment factors, also explains why returns tend to have a relatively low correlation to bond and equity markets.

For example, since launch, the correlation of AIMS TR’s weekly returns with global equities and global bonds has been around 0.6 and 0.1 respectively.⁷

Historically, global macro funds have tended to perform better in higher inflationary environments. This is probably, at least partly, explained by the fact such periods tend to be accompanied by higher volatility. Greater dispersion in asset returns makes for a riper feeding ground for managers. 

To maximise the probability of achieving excess returns through good times and bad, AIMS TR seeks to construct a well-diversified and risk-controlled mix of strategies, seeking additional return drivers outside of traditional long equity and credit markets. AIMS TR is a discretionary fund, deploying traditional macro-driven trade ideas alongside quantitative insights and systematic strategies.

Embedding diversification and resilience is a key area of focus in our investment process. The fund is composed of 20-30 diversified strategies. It can take long and short positions across multiple risk drivers.

Across the world, there is a growing list of governments whose instinct is to care less and less about rising public debt levels. Even where fiscal sustainability may not be an imminent concern this risks reigniting inflation. Bond volatility looks to be here to stay and with it the search for portfolio diversification.