By Darius McDermott
I wonder how many readers will have played the game Buckaroo?
For those that have not, it is essentially based around a plastic mule that is sensitive to pressure – the mule (called Roo) begins the game standing on all four feet. Players take turns placing various items onto the mule’s back without causing the mule to buck up on its front legs, throwing off all the accumulated items. If he does it on your turn, you are out of the game.
It is a good analogy for markets at the moment. The bucking mule is recession, and the various items (interest rate hikes) are being strategically positioned by central banks to tackle the threat of inflation.
It comes to mind because, having seen bonds and equities pummelled in the first half of 2022, there are a few signs that things are starting to change – with global recession fears starting to replace inflation as the principal threat to markets.
For example, the commodities market implies recession fears are trumping inflation, with the price of numerous industrial materials – an indicator of activity – witnessing significant falls. Could recessionary Roo be about to buck?
The path to higher interest rates is painful, but it should ultimately give bond investors opportunities in the longer term. That is welcome news for an asset class that has already seen some £6.6bn of outflows from retail investors in the first five months of the year.
In the first half of the year, the S&P 500 was down 20 per cent, while the broad US aggregate bond market was down 10 per cent. This is the first time bonds have not delivered positive returns when equities dropped by such a magnitude since the 1970s.
There will come a time when the final rate rise will come into view and all the bad news has been priced into the market. If recession comes, we will ultimately see rates stop rising (and eventually fall). And as soon as markets price that in, bond prices will rise. Timing that is almost impossible, so building a position now is worth considering.
Vincent Ropers, fund manager of TB Wise Multi-Asset Growth, says a good degree of downside news is already being priced in, meaning yields now offer a greater degree of protection, at around the 3 per cent level in US 10-year government bonds, 2 per cent in the UK, and 1 per cent in Europe.
He says with recession now looming large, bonds can act as a diversifier to equities – adding that with current bond yields offering a greater margin of safety, a compelling opportunity has arisen, meaning the team are subsequently allocating towards traditional bond strategies for the first time in years.
The challenge is timing these changes. In my opinion credit spreads will continue to widen, which will make investment grade and high yield start to look more compelling. But the rapid rise in interest rates from the US Federal Reserve will expose hidden leverage and cracks in the economy.
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