Re-thinking diversification

Why have markets been so volatile?

Chris Iggo, Chair of the AXA IM Investment Institute and CIO of AXA IM Core

There have been a lot of events creating uncertainty in over the past few years: COVID-19, inflation, monetary tightening.  More recently, the source of uncertainty has stemmed from the US and the economic policies of the Trump administration. Its flagship policy has been trade tariffs. At the moment, the effective tariff rate of imported goods into the US is around 15%. Given that the US imports around 13% of its GDP, this tariff tax could have a significant impact on the US economy. In fact, there is already evidence of this impact: Inflation is higher, and the labour market is weakening, which is what you would expect from an increase in, what is effectively, taxes.

While still early days, it could be that performance of the US, and the global, economy may now deviate from what it would have been. So, there are reasons why investors are cautious. However, the markets don’t seem so concerned – equities markets continue meet all new highs and bond performance is good.

The influences on the rates market

We have been going through a rate normalisation process for the past few years, after many years of quantitative easing and central banks intervening in the global markets. That means we have to think about “what is the fair value for government bond yields?”.  We are probably in the fair range if we look at historic yield levels. Of course, it is likely to move around which is what we have seen with US Treasury bond yields, which have traded within a range of 4% and 4.8%. It has stayed in this range but moved around quite a lot, creating volatility. 

A second influence is monetary policy and what central banks are doing. The European Central Bank (ECB) is ahead of most and seems to have almost completed its rate cutting cycle. The Federal Reserve, on the other hand, still has some way to go. Therefore, the trend towards yield curve steepening is likely to continue.

Finally, it is worth considering the impact of fiscal policy. France and UK are both examples of countries where government debt and budget deficits are having an effect on the bond market. This has resulted in an increase of risk premium at the long end of the curve – and this fiscal issue is one that can be seen globally.

Will credit continue to perform?

Credit spreads are very tight but if you look at the fundamentals, we think there is little to be concerned by; corporates are in good shape with healthy balance sheets, high cash levels and strong corporate earnings. This means that corporates should be able to manage their debts comfortably. You could argue that corporate balance sheets are in better shape than government balance sheets. This supports credit spreads staying tight.

Another way to look at credit is at the overall yield in corporate bonds - they are very attractive and well above the rate of inflation. Given this level of yield, investment grade bonds, with the lower chance of default, offer potentially good returns in comparison to government bonds, while also providing diversification of cash flows through different industries, issuers and time horizons. It is also possible to diversify the credit risk through ratings, sector or country allocation. For these reasons, we remain positive on credit.

How to address downside risks in fixed income

Johann Plé, senior portfolio manager, and Rui Li, portfolio manager

In an environment where the duration accounts for more than 80% of the volatility in a fixed income portfolio, duration today is no longer merely a strategic asset allocation choice. Instead, it has become a tactical lever to manage portfolios’ risk-adjusted return profile. 

We believe that to harness duration effectively, you need flexibility. Rate volatility is significant but with flexibility you should be able to seize on opportunities to mitigate drawdown risk in a rising rate environment, as seen in 2022, or when rates rally. In this recent period, it has been important to be able to take advantage of both approaches.

When we look at different flexible investment approaches, be it a euro fixed income strategy or a global green bond strategy, a flexible approach to duration helps to create opportunities. Volatility has been an opportunity for both types of strategies, and with the right levers, it is possible to create a more attractive risk -return profile through diversification. It’s important to remember that when we talk about duration management, it is a gradual implementation; a deviation between the short-term market pricing and the medium to long term view.

A long-term view is an important factor of a diversified portfolio. Take credit spreads, which have seen a significant rally recently, but over a longer period of 25 years, we have found that there is almost an 80% chance that we will see the spread move wider in the following years¹. This is when a diversified portfolio^* tends to be more resilient, outperforming credit 74% of the time.¹

Given the current market environment, we believe it is important to be cautious as the upside potential for a rally is limited while the risk could be quite asymmetric. Therefore, combining flexibility and duration management, we think, is key when aiming to achieve superior long-term risk-adjusted returns in the current market environment.

The crucial role of diversification

A diversified portfolio tends to have a more robust risk-return profile with better Sharpe ratio² and limited drawdown and, we think, this still applies now especially as credit spreads remain tight. So, although we remain comfortable with credit, we are also looking to create further diversification. This is because we believe that we might not be as well rewarded for the additional risk if we continue to focus just on credit. So, we are expanding into sovereigns, and quasi sovereigns while focusing on carry from short-dated subordinated debt, as well as emerging markets. Another diversifying lever for us in our flexible strategies is inflation-linked bonds as it should provide downside mitigation. Not only can it be used as an instrument to try to hedge inflationary risk, but it may also potentially generate additional carry, without the credit risk associated with corporates.

A different way to approach a global fixed income portfolio is through green bonds. While there may be push back on green financing from the US government, there is still momentum from businesses. We are also seeing this further afield with increasing funding to renewable energy. The increased demand for electricity thanks to the greater use of technology, the rolling out of more electrification of buildings and transport systems, means that demand for renewable energy is likely to increase. Green bonds should be a key route for these projects as they deliver stable financial costs for the project developers while they offer investors transparency and a high level of reporting.

We expect the green bonds market to continue to grow on a global scale with Europe leading the way but the US, and beyond, will continue to invest in this area. This can already be seen by the fact that the sustainability bond asset class has about 15%-20% in emerging market which provides interesting geographic diversification. In an environment with a lot of policy risk from the US, it is important to expand beyond the US.

Bond markets feel attractive today. Yields are high and with a high level of economic and political uncertainty, we believe that it is a good time to look at bonds. They can offer diversification against riskier assets. However, the journey is still unlikely to be a straight line which is why a flexible approach may be of interest for investors.