We see raising portfolio resilience as a key theme for investors – not only for this year but over a long term. It’s crucial to safeguard a portfolio against a variety of adverse conditions, especially in a time of elevated macro uncertainty. We view government bonds as key portfolio ballast, even after their yields have plunged.
The hope when holding government bonds in a multi-asset portfolio: Bond prices should rise when stocks fall, cushioning the overall portfolio impact of “risk-off” episodes. This has generally been the case since 1980, according to our study of the correlation between the performance of U.S. Treasuries and stock market, and that of German government bonds and European stock market. There have been exceptions. Take the “taper tantrum” of 2013: Then Fed Chairman Ben Bernanke hinted at reducing post-crisis monetary stimulus, sending both stocks and bonds lower. But such events have been relatively uncommon, especially since the global financial crisis. The chart above shows the U.S. and German government bond performance during stock selloffs in their corresponding markets since 2000. We see government bonds providing important ballast against risk asset selloffs in the current environment, as trade and geopolitical frictions become a key market driver.
In search of ballast
The protection offered by global government bonds is still meaningful even as their yields have hit historical lows, in our view. Take German government bonds (or “bunds”), which have one of the lowest yields globally. The worry for investors: euro-zone policy rates–already in negative territory–may be nearing an “effective lower bound (ELB),” or the minimum level of interest rates that central banks can feasibly set. This would suggest there is little further room for bund yields to fall–and their prices to rally–during equity market selloffs. The ELB is tough to estimate and its level can change over time. Some studies, including one from Princeton economist Markus K. Brunnermeier, pin the euro area’s ELB around -1%. This (albeit highly uncertain) estimate would imply that euro area sovereigns still have some room for yields to decline, but they offer a thinner cushion than in the past against major equity shocks.
We see an important role for inflation-linked bonds, both as a ballast to equity selloffs driven by growth shocks and to underappreciated inflation risks. Inflation-linked bonds generally rally when equity markets sell off, like nominal bonds. The potential unravelling of global supply chains over a longer horizon, as a consequence of protectionist policies, could lead to an unwelcome mix of sluggish growth and higher inflation–and a difficult environment for both equities and nominal bonds. A blend of nominal and inflation-linked bonds in strategic portfolios can create resilience to a variety of adverse conditions. In addition, low inflation expectations have made inflation-linked bonds inexpensive, adding to their appeal.
We stress the importance of government bonds in building portfolio resilience, yet there are tactical considerations to take into account. We see potentially better entry points for U.S. Treasuries in the next few months relative to bunds, especially if the Fed’s policy meeting this week–or in coming months–moderates some of the excessive market expectations for easing measures. Tactically we favor European sovereigns with a preference for peripherals, given our view that the ECB is likely to meet–or even exceed–market expectations for further easing.