As the relatively sluggish European economy continues into 2020, what should we consider when it comes to building portfolios?

Euro investors holding cash find themselves in a truly uncomfortable position; assuming the ECB’s negative interest rates are passed on, depositing cash in the bank will mean losing 0.5% per annum. Add in the cost of inflation at c. 1% and one’s purchasing power of parity is declining by 1.5% per annum. We live in unprecedented monetary conditions, to which there seems no obvious end in sight.

There is no easy fix, so our clients are using an array of approaches to tackle the issue, with the common theme of trying to achieve positive carry at the lowest perceived risk. The first important point to highlight is that, despite negative yields, we feel that government bond exposure remains crucial in portfolios and that negative yields do not necessarily indicate poor value.

Lets take the example of the 10 year German Bund, currently yielding c. -0.25%. Intuitively, this makes little sense to invest in but looking at it from a global perspective shows otherwise. Because of the wide gap between the Federal Reserve’s (the Fed’s) base rate, +1.75%, and the European Central Bank’s (ECB’s) base rate, -0.5%, a USD investor will be paid c. 2.3% to hedge their currency exposure into Euros. Assume that money is invested in the 10 year Bund; the recipient receives a net yield of c. 2%, which is a premium to the yield obtainable in the equivalent USD Treasury. This hedging dynamic underpins strong demand for European government bonds from USD-based investors, who represent a substantial portion of global bond ownership, and shows that European sovereign bonds are fairly priced in a global context.

While it remains our view that most regions of the world will continue to avoid recession in 2020, the relatively sluggish European economy reminds us that we must account for the possibility of weak or negative growth when building portfolios. Most financial assets, like equities and credit, perform well when growth is strong. But when growth is weak or negative, the key asset class you need to hold in your portfolio is high quality government debt with long duration. Why? Because if data slows and inflation lags central bank targets, investors can make capital gains as yields fall, just as we saw in 2019. Could that occur again in the future? Absolutely. The following is an illustration of the annualised returns one could make if Bunds moved back towards their previous lows:

Figure 1 - What if Bunds moved back towards their previous lows

Source: J.P. Morgan Private Bank CIO.
Table shows an example of German Bunds, and what it means if they move back towards their previous lows. Beginning with 10 year Bund yield, the yield change and the total return in 12 months.

The first interesting point is that if rates stay unchanged at the end of the year, the impact of the maturity falling from 10 years to 9 years means that one achieves a positive return.

The second point to highlight is the positive total return one can make in the event of slowing growth/recession. In this scenario, far better to hold longer dated fixed income than cash.

Moving on to asset classes that we see as less attractive from a risk/reward perspective - lower rated corporate credit and high yield. An alarming proportion of the investor community seem to be judging fixed income investments relative to the degree of positive yield, rather than on the fundamentals. Figure 2 illustrates where the spread for high yield bonds (i.e the amount of extra yield vs sovereign bonds) is vs history:

Figure 2 - Spread for high yield bonds vs history

Source: Bloomberg 18/12/19.
Shows the spread for high yield bonds versus history, covering EUR High yield OAS, Average EUR HY OAS, EUR upper 1 standard deviation band and EUR HY lower 1 standard deviation band.
Spreads as low as this suggest that investors consider negative growth shocks and/or recession as very low. That seems mispriced to us given current market dynamics. Indeed, Q4 2018 provides a useful illustration of how credit can perform vs Treasuries as recession risk increases:

Figure 3 - How credit can perform vs Treasuries as recession risk increases

Source: Bloomberg 18/12/19.
Shows how credit can perform versus Treasuries as recession risk increases.

In a recession or slowing growth, central banks tend to step in by cutting interest rates, causing positive returns for sovereign bonds while corporate credit and high yield tend to suffer losses as spreads widen (over concerns of default). The problem Euro investors face today is that to get a positive yield, one is pushed towards those segments more vulnerable to spread widening rather than those that can protect. This means that government bonds play a unique and distinct role in portfolio solutions.

Our first conclusion therefore is that if one is looking to fixed income to combat negative real yields, building a portfolio made up solely of positive yielding bonds could be a pyrrhic solution, given high credit valuations and vulnerability to a weaker macro climate; quality government bonds should also play a role.

But is there an alternative to pure fixed income as a solution? Unfortunately, there is no ‘silver bullet’ answer and the history of ‘black swan’ events tells us that markets will most likely play out differently, or at least for different reasons, than we expect. While it may be unfashionable, in our view the best way to address today’s negative-yield environment is to turn to portfolio construction and the concept of asset class diversification with the potential for negative correlation i.e. what is good for one asset class is bad for another and vice-versa.

The following diagram is a simplistic illustration of the point (For illustration only):

Simplistic illustration of growth rising or falling and the Asset Class preference.

For many investors, the concept of introducing equity risk into the solution for negative rates is a step too far. But let’s consider the fundamentals. Looking at equity valuations, while we would not argue that they are cheap, forward looking earnings multiples are only somewhat above long term averages and with interest rates at historic lows, this seems rational. We don’t expect inflationary pressures, indeed we think Central Banks are more concerned about inflation not meeting 2% targets and therefore will remain accommodative in policy. It is worth looking at investor flows because these are historically good indicators of where excesses may be building. According to EPFR* data, in the eleven months to end November 2019, some $250bn was withdrawn from global equities, while $550bn was invested into global bonds (just $57bn of the flows went to sovereign bonds while $364bn went to corporate bonds and $66bn into high yield and Emerging Market debt) and $523bn into money market funds. On money flows alone therefore, it is hard to say that equities are pricing exuberance.

If we are looking for assets that can provide growth-like returns, we think that credit has less attraction on a risk/reward basis than equities. Credit can correlate with equities to the downside at times of stress rather than provide protection (fig. 1), yet will not provide the same upside as equities in the event that economic data improves. So although equities are a more volatile asset class, our preference is to pair equities with government bonds that can appreciate at times of more sluggish growth. Tactical allocation can be determined by the probability one assigns to the different market scenarios; if one’s main concern is the threat of a recession, the fixed income component should be higher.

CONCLUSION

Our conclusion is that, given we are relatively long in the current cycle, there are greater risks to picking just one asset class to overcome negative real rates than if we were mid-cycle. And the problem with turning to cash and ‘waiting for the dip’ is that few investors are brave enough to buy the dip when it happens – January 2019 did not see significant flows into risk assets, nor did the next opportunity, May 2019. Alternatively, there is the risk (our central case) of an extended period of a low growth, low inflation with small bouts of volatility, which present no obvious entry points, meaning that inflation is steadily eroding one’s future purchasing power.

The economic scenarios where the construct of equities and government bonds will not work are either:

  1. Inflation considerably above expectation or
  2. Severe recession

We place low probabilities on both but under scenario 1, holding cash or traditional fixed income will be no protection. Under scenario 2, the best protection is longer dated sovereign bonds, despite negative rates, rather than cash.

On the balance of probabilities, and accepting that avoiding negative real rates will require some form of risk taking, we see a bar-belled multi-asset class approach as our preferred approach. It is worth highlighting that 2019 demonstrated something important; despite barely positive yields at the start of the year, European government bonds posted strong returns as they reflected low growth, low inflation, and reasonably-valued fundamentals. A good reminder that yield and total return can be very different things.