Looking under the hood, it makes perfect sense. Last year government bonds were dragged down by both higher break-even inflation rates and lower real rates compared to recent years when they have tended to move in the same direction.
Breakeven, or bond market discounted inflation, is closely tied to cash flow from equities, which have rarely done better: Global profits rose 53% in 2021, broadly in line with historic ‘beta’ movements in expected inflation. At the same time, real returns, or the discount rate applied to future cash flows, have rarely been so favorable. Real yields as low as -120bp at 10yr and -60bp at 30yr have been a panacea for stocks, as shown in Figure 1.
Presentation of the base case
In line with consensus, we forecast above-trend growth in the G10 economies in 2022, with inflation peaking around the summer and monetary policy generally declining. We expect the Federal Reserve to hike U.S. interest rates three times in 2022, the ECB to keep rates low longer, and the Bank of England to lag behind.
Better nominal growth rates should support fair growth in corporate earnings, and with generally healthy balance sheets, asset holders across the capital structure should do relatively well. The consensus is for earnings growth of around 8% over the next two years.
The broad base scenario setup would favor both stocks and corporate bonds.
What are the risks ?
The left tail of this baseline scenario is growing, indicating risks to the underlying assumptions.
We enter 2022 with âneutralâ prudence in our risk-taking from an asset allocation point of view, i.e. a little below the midpoint of tracking errors or portfolio volatility.
In the context of general risk neutrality, our exposures are oriented towards a short duration, selected long equity markets and, more tactically, long commodities.
A particular risk that concerns us is reflected in this positioning: a prospective de-anchoring of bond yields, and real yields in particular, at a time when asset valuations in general are full.
It’s not difficult to argue for higher bond yields and higher neutral rates, especially at current valuations.
- The past two years have seen global monetary and fiscal stimulus on an unprecedented scale outside of times of war. This is now in the process of being resolved.
- Labor markets are increasingly tight in many developed countries, with a return to the bargaining power of labor for the first time in three and a half decades.
- Globalization, which has played an important role in the steady downtrend in bond yields since the mid-1980s, is in reverse.
- And the inflationary shock caused by COVID-19 has been both large and more persistent than expected, but the financial conditions are extremely easy.
A rise in bond yields will likely be boosted by ultra-low real yields that rise as central banks tighten policies, rather than breakevens.
At the same time, the cycle of brutal rate hikes integrated by the markets seems curious to us; we would rather see a steepening of the curve, especially in the United States, than a further flattening as the Fed removes the punch bowl. Today, about a quarter of our risk budget in an unconstrained multi-asset portfolio would be spent selling US and European government bonds.
As higher bond yields increase the discount rate of equities, multiples can be called into question (see Figure 1).
A look at our positioning
The price-to-earnings ratio in the US stock market is as high as ever since the late 1990s, and the dividend yield is a few steps from the lowest. Nevertheless, we continue to favor equities: they represent the bulk of our overall risk.
However, we are increasingly focusing on regions which we believe are both less sensitive to changes in real returns at current valuations, and where strong cash flows are expected in 2022 and 2023 in terms of both. absolute and relative. Europe excluding UK, US small caps (vs large caps), Japan and – to some extent – emerging markets all exhibit this combination (see Annex 2). In particular, domestic monetary policies in Europe, Japan and China remain accommodative or soften on the sidelines, providing a counterweight to the rise in US real rates.
Japanese stocks, for example, have always tended to outperform global stocks in times of rising US real rates.
On the one hand, this reflects the long operating leverage of Japanese companies (with high variable fixed costs offering good gearing over the cycle). On the other hand, overall, companies have low financial leverage (with the highest cash balance of any major market).
Valuations in Japan today are cheap, earnings expectations are dynamic, and policy remains accommodating (monetary) or easing further (fiscal).
More tactically, we also favor commodities which should be supported by the change in tone in Chinese politics, significant supply shortages and a broader insensitivity to fluctuations in cash flows or discount rates.
 As measured by the Global Aggregate USD Uncovered Bond Index and the S&P 500 and MSCI ACWI Equity Indices respectively. The first quarter of 2021 was scorching for government bonds as they experienced their worst performance in 40 years.
 2018-2020, for example, where breakevens and real returns have similarly declined
 This can be viewed as the slope of the line of best match between expected risk and expected return in all asset classes. The steeper the line, or the higher the expected return per unit of risk, the greater the risk appetite. Neutral is in the middle quintile (20%) of a tracking error or allowable volatility.
All opinions expressed herein are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may have different opinions and make different investment decisions for different clients. The opinions expressed in this podcast do not constitute investment advice in any way.
The value of investments and the income from them may go down as well as up and investors may not get their original stake back. Past performance is no guarantee of future returns.
Investment in emerging markets, or in specialized or small sectors is likely to be subject to above average volatility due to a high degree of concentration, greater uncertainty as less information is available. available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions). Some emerging markets offer less security than the majority of international developed markets. For this reason, portfolio transaction, liquidation and custody services on behalf of funds invested in emerging markets may involve greater risk.