Climbing up the curve

Longer-duration bond assets are starting to outperform shorter-duration bonds. This makes sense given the steeper yield curves delivering higher carry in longer-dated bonds. Whether this is compelling enough to shift allocations in bond portfolios remains to be seen. If it does, growing concerns about credit will also be a significant part of the motivation for such changes.

• Key macro themes – forecast growth is tepid, don’t ignore that
• Key market themes – borrowing by technology companies is getting creative

Seasons change

It is becoming more difficult to forecast sustained high real returns in public markets. Equity and credit market valuations are expensive, US and UK inflation has been above target since 2020, public debt issues are suggesting an era of fiscal dominance with potential currency debasement, and there are lots of well-known macro and political risks. Alternative asset classes, however, have continued to attract capital through offering different risk-return profiles. Hedge funds strive to deliver uncorrelated (and high) returns though combinations of high frequency, complex and leveraged investment strategies. Private credit potentially offers higher returns for giving up some liquidity. Private equity vehicles can provide access to high returns through pre-initial public offering investing, which - in a world where the artificial intelligence (AI) value stream is evolving rapidly - can be very enticing. Gold trades on its rarity value, its ability to hedge against inflation and lack of correlation to equities. Cryptocurrencies appeal to some for many reasons – not being part of the centralised global financial system (ahem) being one of them. 

It is harder to assess these factors in alternative assets (some would say by definition) so it is equally hard to assess when the risk premiums don’t compensate for fundamental or technical risks. As a result, news that impacts sentiment is important. There has recently been a large bankruptcy in the US and some concerns about regional banks. If news suggests credit problems, even in the opaquer parts of the market, then liquid markets will get hit. The good news is that, in the current earnings round for US companies, banks have not raised any red flags on credit quality or loan losses. It should be noted, however, that following renewed concerns about US-China trade relations, spreads have widened. This may be temporary but the likely evolution of spreads over coming months is probably skewed towards widening.

Ready for vol?

The main worry in public markets is valuation. I’ve talked about it a lot so won’t go on. However, I have become obsessive about looking at the relationship between valuation metrics (price-to-earnings ratios in equity markets, spreads in credit markets) and subsequent returns. The stark truth is that the return outlook is not great – depending on the time horizon, barely any real return in US equities over the next 10 years, and barely any excess returns from fixed income credit classes over the next five years. It’s only based on history and spurious regressions, but there is no doubt the market narrative is one of concern about how expensive everything is today (the payback for having made a lot of money over the last three years). When there are widespread concerns over valuation, it does not take much to convince investors to become more risk averse. I would not be surprised if we go through a seasonally typical increase in volatility in the weeks ahead.

Price perfect 

Given the gains in markets so far this year, is there an argument for being more defensive now? Can we rely on markets continuing to dismiss policy risks in the US, geopolitical tensions and valuations? Maybe. Maybe this earnings season will continue to be strong. US bank earnings have been good. European luxury goods results look solid. We only have 10% of S&P 500 company results for the third quarter so far, but growth is impressive (16%). The macro themes that I discussed last week – the wealth effect, strong credit markets and the lack of fiscal austerity – might be strong enough to keep economic growth positive. But market performance is very much reflective of this benign economic backdrop. 

Longer duration? 

Recent years have been torrid for long duration assets in the bond market. However, this may be changing. In the US, UK and Euro Area government bond markets, longer duration has outperformed this year (seven–to-10-year indices versus one–to-three-year indices). That observation may not sit comfortably with the bond bears worried about debt levels and excessive supply. Based on current 10-year versus two-year government bond spreads, history suggests that there will be positive returns locking in the longer yield versus the shorter dated yield. That reflects the additional carry from the longer end of the curve, but there is also the possibility that total returns are boosted by the whole yield curve moving lower (in a risk-off environment) or recent curve steepening reversing at some point. If yield curves keep steepening, the case for longer duration becomes even more compelling. The 10-year/two-year spread in European government bonds is back to its 30-year average level so with cash rates at just 2% the longer end of the bond market is attractive.

Credit, not yet cracking 

It has not been the consensus to be underweight credit and long duration in bonds. Valuations alone suggest that strategy is worth considering, especially if investors do get more concerned about credit issues. There is certainly more borrowing by technology companies taking place, through public debt issuance but also through private credit vehicles. There is more merger and acquisition activity. The AI boom is fuelling animal spirits, and this is flowing into the bond market as well as equities. Our US credit team estimates Business Development Companies (special purpose vehicles that raise money in the public markets to invest in private companies) have about 20%-30% of their funds invested in the technology sector. This makes sense given the amount of money that the big technology companies are spending on the AI roll-out, as there is a significant trickle down the value chain with start-ups getting in on the act. It does not look like the AI bandwagon is coming off the road any time soon. But the question remains as to whether future revenues will generate sufficiently high returns-on-investment to justify the spending jamboree currently taking place. Can the markets continue to allocate more and more to fund AI capital spending at increasingly expensive asset valuations?

Investing to change

It’s trite to say markets are due a correction, but it feels that way. In this job you get bombarded with information. Two things caught my attention this week. Ken Griffin, CEO of hedge fund Citadel, was reported to have said that AI does not help generate alpha in trading and investment. The other was a headline questioning the worth of AI-driven investment advice in the wealth area. Selective, I know. But remember when we all got excited about clean energy changing the world – which it still will, but renewable energy valuations got hammered post-COVID-19. AI seems bigger than the clean energy trade and therefore puts more markets at risk if there is a re-think on valuations. It will change the world, but it’s costing a lot today to make that change.

Learn to like the longs again

Credit spreads are tight, equity multiples are at extremes, and economic growth is expected to be modest (the latest International Monetary Fund forecasts are for advanced economies’ growth to remain at 1.6% for 2025 and 2026 with the US growth forecast sticking close to 2.0%). It might be time to be more defensive, and the longer duration trade in bonds might be part of that. If we get a risk-off period, this trade should work.