Mike Dolan

LONDON (Reuters – Inflation has risen, interest rates have risen and bonds seem like dangerous investments waters – these are all reasons to consider a return to fixed income.

It has been a terrible year, for commodities and oil aside.

The cosh has not affected the interest-rate sensitive securities or the long “duration” play. U.S. technology stocks fell more than 10% while U.S. government bonds lost 5-6%. Additionally, fund managers have a heavy overweight bias in global equity and cash.

Data from mutual funds shows that there have been two months consecutively of outflows to global bond funds. This amounts to a total $32 billion in exits for the entire year.

Investors who fear the demise of the bond bullion market for 40 years are now more concerned about rising oil prices, war tensions and central bank maps that show a return back to pre-pandemic levels.

JPMorgan (NYSE)’s long term strategists, however, take a completely different approach and filter out any turbulent news or macro forecasts. This allows them to create a model of how mix portfolios perform over a 10-year period based upon past performance.

Jan Loeys’ and his team updated this week their outlook on the potential 10-year returns of a standard 60/40 equity/bonds Portfolio. They said that recent asset price fluctuations had significantly increased their expectations for returns compared to a year earlier.

A variety of views on macro drivers may exist, but they are difficult to predict for more than 10 years. The JPM team insists that historically the yield has been the best indicator of bond returns in the following decade.

Today’s yield stands at 2.7%, after an increase of over a percent in U.S. Aggregate Bond Index yields. These include Treasury bonds and agency bonds.

Importantly, they are now positive in real and inflation-adjusted terms.

JPM estimates that a 60/40 mix portfolio has 4% annual returns, and that there was a pullback of U.S. stock multiples. This is a percentage point more than last year, and 1.6% better in real terms. However, it’s still not attractive historically and well below the real average of 5% over the past century.

However, they concluded that this increase in mixed returns might be sufficient to dissuade potential investors from TINA (there’s no alternative) phenomena which at least partially drove the equity price boom in recent years as bond yields fell.

They stated that clients have been less inclined to over-weight equities in order to get portfolio returns closer towards one’s needs. It’s a good idea to rebalance towards bonds at the margin, but not in a rush.

(Graphic: US aggregate bond yields vs and inflation expectations, https://fingfx.thomsonreuters.com/gfx/mkt/egpbklryrvq/One.PNG)

(Graphic: JPMorgan chart on yields vs returns over 10 yrs, https://fingfx.thomsonreuters.com/gfx/mkt/klpykmagxpg/Two.PNG)

BINDING CONDITIONS

Although it’s not consensus, this view is consistent with certain fundamental arguments. These include central banks being quick to act now; peaking inflation and better real returns; cooling down growth and flattening yield curves; as well as the notion that positive real yields from “safe assets”, which are appealing right now for risk-averse funds.

The “defined-benefit” pension industry’s dynamics were widely discussed last year. This was a factor in steamrolling yield curves and impacting long-term yields. Excessive equity gains and full-funding status havetened full-funding and an mass “derisking” of portfolios towards bonds.

These signs may also indicate that more tactically active managers have been influenced by the recent bond market volatility.

PIMCO chief investment officer Dan Ivascyn claimed this week that although his portfolios remain underweight, the valuations are now more intriguing. “I believe we’re not far off levels when we’ll start to reduce the duration underweight.”

Chartists who map 10-year Treasury yields agree that calling the end to the bond bull market of 40 years would be premature.

One of the main problems with JPM’s long-term view is its reliance on past performance. This can be a problem if you believe we are in for a major shift in world economics where credit spreads and bond yields will continue to rise.

Euan Munro is the Chief Executive of Newton Investment Management. He wrote this month about how markets were hitting “boundary conditions”. This should prompt a review of 60/40 portfolios to ensure a better and more actively managed fixed-income portion.

He was most upset with the historical performance of modelling because it assumed a questionable view that the future would repeat the past.

“Those using such an approach, regardless of whether or not they are aware, make or at least suggest quite detailed predictions about future market conditions.”

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The editor-at-large of finance and markets for Reuters News is the author. All views and opinions expressed in this article are the author’s.

(by Mike Dolan; Twitter (NYSE): @reutersMikeD, editing by David Evans