MIKE DOLAN: JPMorgan makes case for ‘rebalancing towards bonds’

London — Inflation is raging, interest rates are rising and bonds look like treacherous investment waters — all of which make arguments for a dip back into the fixed income vortex intriguing at least.  

To be sure, it’s been a lousy year so far for most asset classes aside from oil and commodities.

But the most interest rate sensitive securities, or long “duration” plays, have been under the cosh. Government bonds have lost 5%-6% while US technology stocks are down more than 10%, and fund managers are heavily underweight in both, with a overweight bias for global equities and cash.

Mutual fund data shows two consecutive months of outflows from global bond funds, a cumulative $32bn exit for the year to date.

Spiking oil prices, tensions over war in Eastern Europe and central banks mapping a return to pre-pandemic monetary settings all stir the water for investors who are once again fearful of an end to the 40-year bond bull market.

But JPMorgan’s long-term strategists take a different tack and screen out all the turbulent news, macro forecasts and tactical trading views to model how mixed portfolios would perform in a 10-year view based on past performance.

Jan Loeys and team this week updated their view of prospective 10-year returns for a standard 60/40 equity-bonds portfolio and said the recent shakeout in asset prices lifted their expected returns significantly from a year ago.

Dispensing with different takes on macro drivers — which may be valid but impossible to predict with any certainty over 10 years — the JPMorgan team insisted the best guide to bond returns over a subsequent decade has historically been the prevailing yield.

The jump of more than a percentage point over the past year in yields on US aggregate bond indices — which include Treasury and agency bonds as well as investment grade and high yield corporate debt — now put today’s yield at about 2.7%.

Crucially, this makes them positive again in real or inflation-adjusted terms when using 10-year market inflation expectations of 2.4% as a guide.

Along with a pullback in US stock multiples that improves their annual return outlook over the next decade to 4.8%, JPMorgan believes a mixed 60/40 portfolio’s prospects were now 4% per annum. That is a percentage point higher than last year and 1.6% positive in real terms — even if still unattractive historically and far below the real 5% average of the past century.

But their conclusion was this improvement in mixed returns may be enough to dissuade investors from the TINA (there is no alternative) phenomenon that has at least partly driven the equity price boom as bond yields were floored in recent years.

“The urge to overweight equities to bring portfolio returns closer to one’s requirements has been softened,” they told clients. “At the margin [it’s] a reason to start rebalancing towards bonds, without having to be in a hurry.”

Boundary conditions

While that is hardly consensus, the view does chime with some fundamental arguments — such as central banks acting swiftly now; peaking inflation rates and improved real returns; cooling growth and flattening yield curves; and the idea that any positive real yields in “safe assets” are attractive right now to risk averse funds.

Dynamics in the “defined benefit” pension fund industry, for example, were widely cited last year as a major factor steamrollering the yield curve and weighing on long-term yields as outsize equity gains hastened full-funding status and a mass “derisking” of portfolios into bonds alone.

For more tactical active managers, there are also signs that this latest volatile period may have overdone the bond gloom.

Pimco chief investment officer Dan Ivascyn said this week that his portfolios remained underweight bond duration but valuations had now become more interesting. “I don’t think we’re too far away from levels where we'll begin to reduce that duration underweight.”

Even chartists mapping 10-year Treasury yields think calling the end of the 40-year bond bull market would premature at least.

The main criticism of that long-term JPMorgan view of course is that it relies on past performance as a guide, reasonable unless you think we’re in for a paradigm shift in the world economy where bond yields and credit spreads have nowhere to go but up.

Newton Investment Management CEO Euan Munro wrote this month that markets had hit such “boundary conditions” and that should force a rethink of 60/40 portfolios towards a more diverse and actively managed fixed income portion at least.

His main bone of contention with modelling based on historical price performance was that it did in fact assume a questionable view the future repeated the recent past.

“Those that apply such an approach are making — or at least implying — quite a detailed forecast of future market conditions, whether they realise it or not.”

Reuters