Long bonds vulnerable to reversal
Shifting to shorter duration positioning
The month of May proved to be a challenging one for global financial markets. A seemingly sanguine macro environment – characterized by reflationary policy in China, a dovishly pivoting U.S. Federal Reserve, constructive trade negotiations, and stabilizing global economic data – was disrupted abruptly. With the U.S. accusing China of reneging on previously-agreed-to facets of a deal, trade talks fell apart, and tariff threats and impositions began to fly. Beyond trade, the conflict between the world’s two largest economies deepened, as the U.S. used a national security order to effectively ban Chinese technology giant Huawei from the U.S. market, while Google severed ties with Huawei’s smartphone business.
Predicting short-term geopolitical outcomes is an extraordinarily difficult task (especially in the new “Twitter era”), and one that is fraught with risk. At Forstrong Global, our investment process seeks to avoid binary decision-making and instead weighs comprehensive scenario analysis against what financial asset prices are telling us. Currently, the bond market appears to be convinced of an impending recession. Per the chart below, 10-year bond yields are now hitting multi-year lows in major economies worldwide.
A large proportion of the U.S. Treasury yield curve is inverted, and corporate high yield spreads have surged anew. While an escalating trade war certainly poses significant risks to the global economy, we believe the sharp fall in longer-term bond yields has overshot the mark.
A number of factors contribute to this view. Although many global central banks are eager to “restock their toolkits” following a prolonged period of loose (and unorthodox) monetary policy, worsening trade tensions would likely require further incremental accommodative measures. India and Australia both recently cut policy rates, while U.S. Federal Reserve Chairman Jerome Powell publicly acknowledged an openness to lower rates should conditions deteriorate.
As policy overtightening is the most frequent cause of recessions, trade hostilities may actually end up extending the business cycle. Additionally, the recent fall in oil prices (primarily due to global demand concerns) will be supportive of discretionary income for consumers and lower transportation costs for corporations.
Lastly, despite aggressive rhetoric of late, it would be premature to completely rule out a trade deal, which would ultimately be in the economic best interests for both China and the U.S.
Our global strategy overview
With these counterpoints considered, we are mitigating exposure to longer-dated bonds, which we believe are vulnerable to a reversal. To improve resiliency in client portfolios, we are balancing global equity exposure with cash and shorter-term bonds.
Cash and currency: Cash remains a critical volatility dampener as elevated geopolitical risks continue to reverberate around financial markets. Forstrong’s client portfolios have sufficient “dry powder” should further distortions present opportunities.
Bonds: As discussed above, global bond yields plummeted to multi-year lows in response to a breakdown in trade negotiations between China and the U.S. (with each side levying new tariffs). We believe this move was overdone and vulnerable to a reversal. We have maintained our underweight and short duration positioning.
Equities: Global equity markets sold off in May, as a resurgence of trade tensions caused a widespread flight to safety. Looking forward, short-term volatility is likely to remain elevated unless a “truce” is reached. Ironically, this may actually help extend the business cycle and equity bull market as monetary policy is forced to turn more accommodative. We remain overweight stocks.
Opportunities: With the aforementioned plunge in global bond yields, investors requiring portfolio income will feel a renewed squeeze. Higher-yielding asset classes should be rewarded, as capital flows will likely rotate towards alternative sources of income. Our exposure to global real estate equities is well positioned to benefit from this trend.
David Kletz, CFA, is Vice President & Portfolio Manager at Forstrong Global Asset Management.This article first appeared in Forstrong’s monthly Portfolio Dashboard. Used with permission. You can reach David by phone at Forstrong Global, toll-free 1-888-419-6715, or by email at email@example.com.
Notes and Disclaimers
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