The behaviour of financial markets has always been unpredictable, but lately markets have been more resilient to changing news flows than usual. Events that would previously have prompted sell offs in both equities and bonds, such as elections and geopolitical conflicts, have stubbornly failed to move the needle on any asset class over the long term. Equity markets remain at historic highs, while high yield bond spreads are flirting with historic lows.
Digging out risk premia
In the fixed income space, yield is particularly hard to come by in terms of both duration and spread premia. Moreover, the risk of rising yields is considered high as central banks prepare for more normalised monetary policy settings. As a result, appetite for short duration and high yield type products has been strong. Similarly, investors have been entering the illiquid space in order to get the levels of returns they would have previously found in liquid debt.
These products tend to perform well if the macroeconomic scenario unfolds in the expected benign way and a lot of investors are playing one side of the risk scale, namely that risk is suppressed, an assumption that has so far been proved correct. However, if there is some kind of turmoil and risk appetite fades, investors are likely to suffer when exposed predominantly to these asset classes, unless they have very long time horizons of ten years or more.
Ready for a rotation
With unusually suppressed headline volatility and high asset prices, a risk-friendly environment is by no means a given. As a result, our focus at Nordea is on building portfolios that can perform regardless of the macroeconomic scenario. While this means we may not keep up with more risk-seeking peers when market conditions are still benign, it should defend the portfolio if markets begin to turn.
We are increasingly struggling to find attractive returns among both defensive and more risky fixed income assets. Investors at the moment seem clearly more concerned about low government bond yields than about tight credit spreads, but we take a more balanced perspective. Some credit spreads today are so low that investors are no longer being reasonably rewarded for the risks that they are taking. As a consequence, we run a tactical risk reduction on the credit side of our portfolios. Although we may have been a little premature in our de-risking, we think it is prudent to approach credit markets with some caution, when spreads are tight and generally unattractive.
Seeking accommodative markets
We are trying to cope with the expensive fixed income markets in different ways. Active tactical asset allocation through frequent adjustments to duration and spread exposures is one way of manoeuvring in an overpriced environment. Using fixed income alternatives within FX markets is another solution that we find rewarding. Securing the optimal strategic and geographical composition of fixed income assets is also very important.
We have generally tilted the portfolio’s geographical exposure towards economies and sectors, where interest rates and credit spreads are closer to what can be considered normalised levels. We thus hold the lion’s share of our high-quality debt in non-continental European markets. From an economic and monetary policy point of view, these markets are much more normalised and have more room for manoeuvre in their monetary policy stances.
The big contrast between the US and Europe is the rate at which the former has recovered. This has left the Federal Reserve with the ability to be more accommodative than the European Central Bank, should global markets take a turn for the worse. The Bank of Canada’s first interest rate move signals that it is also likely to be more resilient in any future rotation. It is assets in economies with the capacity to react to a downturn that are most likely to offer a positive return should the market decline. And with the timing of a decline being ever harder to judge, we believe it is prudent to allocate on this basis.
Karsten Bierre, lead portfolio manager, Nordea Multi Asset Funds