So far, two areas, in particular, have influenced both relative and absolute returns in 2022. Bond duration has brought considerable losses to many low-risk portfolios and target-dated retirement funds. Secondly, currency moves have been incredibly volatile, with the effects whipsawing client returns, adding a layer of volatility on top of already depressed valuations.
Factor #1 | Bond Duration
Regarding bond duration, we were at our shortest going into 2022, which became progressively shorter in the year’s first six months. At the end of September, we started to buy back into Treasurys using the Vanguard US Government Bond Index. Since then, we have been progressively adding to sovereigns, and our current duration for the medium-risk portfolio is one year less than the 40-85 benchmark. We believe that the most significant upward moves in yields are behind us.
The correlation between bonds and equities reached unprecedented levels this year, prompting considerable speculation about the death of the 60/40 portfolio. While a portfolio made up primarily of equities and bonds may not have provided the expected diversification benefits in 2022, we do not assume this will continue to be the case in the future. It has been a globally coordinated central bank policy that drove up returns in both equities and simultaneously bonds, with the mantra from the Fed, the ECB and the BoE and many others being ‘lower for longer’ when referring to interest rate policy. That policy started to seriously unravel from the beginning of December last year as these same central banks had to face the reality of non-transitory inflation and start aggressively raising interest rates.
We had already concluded that if the central banks followed through on their new rhetoric, bonds and equities could fall simultaneously, hence our short-duration position. As we see inflation peaking, at least for now, we think new opportunities are opening up in the bond space. In fact, this is one of the most exciting times for fixed income in a decade. We still expect considerable volatility, but that in itself offers the best bond managers the chance to add alpha to what already looks like a reasonable beta story. The era of peak globalisation is behind us, as is the period of peak central bank coordination, barring a resurgence of the pandemic or something unforeseen. Countries (ex the ECB) will be setting rates for their own country and will come under increasing pressure from politicians to help their economies and help them stay elected.
Factor #2 | Currency
We have opted to hedge most of our global bond holdings, which brings us to a second factor driving returns in 2022, currency. We must pay attention whenever an asset reaches extreme relative highs or lows. We have also learnt over time that at these points, there are always many people who suggest the situation will continue, and it is much harder to make a counterpoint. When the pound reached 103 against the greenback, the consensus was that the pound would go through parity and the dollar would keep getting stronger. At the time of writing, the pound is at 119 against the dollar, predominantly due to the dollar weakening. Still, the pound has also bounced considerably since the depths of the post-mini budget carnage. In this case, we had both currencies’ valuations at levels that had rarely been seen for many years. Within a few weeks, both currencies had catalysts having the effect of a considerable change in their relative value.
Obviously, this hasn’t just affected bond pricing, and in recent weeks we have seen UK investors pay the price of a rising currency. Still, nothing compared to the pain US investors have felt on their overseas assets since the dollar began its seemingly inexorable rise. We have seen FTSE 100 companies with significant dollar-denominated earnings start to underperform their more UK-focused peers for the first time in many months. This underperformance has been exacerbated at a fund level if the funds are not investing in the large oil and mining stocks.
We have been positioning our portfolios with reference to these extreme currency positions for the last few months. As another example, we have hedged 33% of Japanese allocation back to the sterling as the yen has more ability than most currencies to change the performance of the underlying equities. What this amounts to is not a currency call based on conviction but an acceptance of our lack of control over the outcome in the shorter term. We try to reduce the overall volatility at a geographical or sector at an asset level which ultimately helps reduce some of the most severe outcomes dictated by currency moves.
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IAM 324.11.22
