Over the past 18 months, we’ve all learned a thing or two as we adjust to life in quarantine. For my part, I mastered the use of a headset designed for pro gamers on pro calls, while using the time I had previously spent in the Metro-North figuring out how to grow vegetables in Connecticut.
In the financial markets, investors have also had to adapt. Stocks are back to all-time highs, inflation is skyrocketing, the political and regulatory climate is a source of uncertainty, and an unprecedented amount of liquidity in the system as well as the huge global demand for US bonds. high quality drove yields to the lowest levels. .
In a way, the past 18 months haven’t been entirely different from the past 10 years of managing diversified income portfolios. The market comes and goes, but ends up going up over time. But there are a few things that surprised me over the decade of managing the Multi-Asset Income Fund that will likely shape the way we think about finding compelling income and returns over the next decade.
First, in 2011, I never thought that the Fed’s zero interest rate policy would still be in place 10 years later. Also, it’s pretty crazy that we have record stock levels and strong global growth coming out of the pandemic, but the 10-year Treasury yield is about 40 basis points below the 1 level, 97% when we launched the fund. And even looking at the 10-year forward curve today, the market is forecasting the 10-year yield to be 2.3% in five years, which is certainly not what many investors thought there was. ten years. We ran large deficits, more than doubled the market value of outstanding Treasury debt, yet the market views growth prospects as stubbornly fragile.
So what does this mean for investors? Don’t expect much from core fixed income in the coming years. There is a close historical relationship between starting returns and forecast returns. This means that if the market estimates that the 10-year Treasury yield is still only 2.2% in 5 years, you are unlikely to expect much more than that in terms of total bond yield. basic. This is why we continue to embrace areas such as high yield bonds, bank loans, high quality dividend stocks and covered call options. This diversification and willingness to take more risk in search of income and returns may be more crucial in the future than it has been in the past 10 years.
The second thing that surprised me is the outperformance of the United States compared to Europe. While I thought US stocks would dominate, the S&P 500’s over 350% return over the past ten years easily beats the around 125% move in the EuroStoxx. Adding emerging markets to the mix gives an even more pronounced picture: Broad emerging market equities (as measured by the MSCI Emerging Markets Index) have risen by around 70% over this period, the most of this return comes from dividends and not from price movement. While this level of outperformance going forward is not sustainable, I believe it signals to investors that winners can continue to win, even in the face of high valuations and a myriad of headwinds and uncertainties they face. may be faced. Does this mean equity diversification is dead? No, quite the contrary, because some of these losers may become outperformers in the future. But it highlights the diverse nature of the US market and its ability to outperform over time.
Third, returns in virtually every fixed income sector have fallen dramatically, a drop that I didn’t necessarily think was possible. For example, the average yield on high yield bonds (as represented by the BBG US HY 2% Issuer Cap TR Index) has dropped from ~ 9% to around ~ 4% today. Yields on investment grade bonds (as represented by the BBG US Corp Bond TR Index) have hit an all-time low of around 1.7% and aren’t much higher today. Why is this important? As inflation rises, the real return on virtually all high-quality bonds is negative. In addition, a record number of bonds are now rated triple B – the lowest rating to qualify as investment grade. This is a sign, in my opinion, that investors are not compensated for the risk they take. While we are not calling for a massive threat to high quality bonds, we are simply emphasizing that unless investors are willing to take a bit more risk in their fixed income allocations, there is a significant risk that the return will not even offset inflation. in the years to come.
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