Pendulums Swing

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Investing Amid Unprecedented Times?

In most meetings, I start by setting the stage as to how extraordinarily poor the performance of fixed income has been in 2022.?

No, I am not kidding.?

Here is a great chart by Alpine Macro that accompanies that statement: ?

US 10 Year Treasuries are a great proxy to pick when generally thinking about Fixed Income. Whether one is an investor, central banker, or journalist, the US-10yr is the most widely followed bond. Now looking at the annual yearly performance since 1873 is a significant time – enough to gain substantial confidence from its message.?

While the calendar year is not yet finished, YTD this year has been the absolute worst…?

In 149 years. ?

While this helps in framing?our own absolute performance by placing a greater emphasis on relative returns; the primary objective is to convey how unprecedented 2022 has been for fixed income investors.?

No recency bias, no exaggeration, no passing the blame – just a clean observation of what 2022 has had to offer thus?far.?

Out of the Darkness?

Clients are usually fast to ask if there is any pattern of poor to great performance in the following year. Unfortunately, while we do not have the exact dataset of the chart;?we have one that begins in 1928 aided by observations from “A History of Interest Rates”, a book I am currently reading - the one my wife asks me to hide before guests?arrive. ?

Given that all the worst years have been observed in the last ~50 years – our dataset should suffice, and from this, we should be able to gain further insights. Indeed, history suggests that many of the worst years are followed by remarkably strong returns; no years produced negative returns, and the average return was substantially above the long-run performance.?

Seeing such consistency in strong returns in the year(s) following those with exceptionally weak performance could be pure luck, however it is more likely be based on the cyclicality of?market responses to prevailing economic and social conditions. When looking back, one finds that emotions, decision-making, and policy responses have been relatively consistent… so why should the response in financial markets be any different? Mania and bursts tend to follow a repeatable pattern, with instinct often taking over.??

While the interpretation of debt and monetary policy cycles may indicate increased conviction versus coincidence, in my opinion, isolated bets on a simple reaction function are insufficient to drive any real confidence in fixed income. ?

Daring to Dream of Decades Ahead?

In a recent presentation, a colleague within the broader organization? Philip Petursson ?shared this chart, comparing historic yields and forward returns. ?

Looking at US Treasury yields again makes sense – as this reflects?the global bond benchmark. With respect to the forward return, the?reason behind selecting an?8-year forward likely lies in the fact that the US Treasury index has a duration of close to 8-years, matching the timeline of the forward-looking returns. ?

The above time frame is sufficiently long to obtain a good sense of the correlation between present?yield levels and the 8-year forward return. While not perfect, the general path of the curves follows quite closely. ??

From the chart we can broadly see that when yields are elevated, one can reasonably expect higher returns over the following 8 years. While not exceptionally surprising, the above visual representation provides context of that poor short-term performance that should not cloud one’s perception of the longer-term potential. In the case of Treasuries, with an absence of credit risk – one can conclude that by-and-large the yield today is a meaningful predictor of 8-year forward performance.? ?

Rebalancing: Expectations and Portfolios?

It is for investors to decide if this is a broad market environment, in which they seek to invest more money. If one liked bonds at?1% yields – it follows that the same investor should love them at 4.5%. Alternatively, one who avoided fixed income at 1% should likely?hate it significantly less. ?

The question evolves; have?we already reached levels that are cheap enough?that we all should be rushing into the Black Friday sale in bond markets, grabbing everything?available? While impossible to say with certainty, at a minimum it appears clear to me that one should consider increasing positions, particularly if/when holding legacy?underweight positions from the zero-interest rate policy regime. ?

What is different now from about a year ago is that when one considers the 3 options: ?

• Recession -> A significant reversal by central banks ->?QE resurfaces -> Markets face a credit crisis?
• Soft-landing –> Broadly stable markets –> No major hikes/cuts –> Stable economic environment?
• Inflationary spiral -> Continued CB hikes – QT Continues – Societal stress?

Fixed income will do well in two out of three; a soft landing and a recession.?

When yields were in the ultra-low region, the return asymmetry was against us, while now even a ‘neutral’ outcome provides a reasonably positive result. There is no reason to turn one’s nose at collecting 4% for US treasuries,?5.5% for Canadian short-term corporates, or real yields of 1.5% (+ inflation compensation) on inflation linked bonds.?

A major recession would amplify the neutral performance by adding some price return to the income generation, particularly if central banks are forced to walk-back their rapid rate hike cycle.?However, a worsening inflationary spiral would likely result in a continuation of the pain for fixed income, however the income from present-day yields provide previously unseen insurance against continued increases in interest rates.?

Investing for Substance over Style?

In my opinion, the most likely scenario is a phase of stability rather than outstanding performance. I also believe that it is important to remember that this is not a bad thing at all.

The baseline path appears to be to get back to a period of lower volatility, a more boring (yet positive) fixed income environment. This would be a welcome change for many of us. A further escalation of price pressures is of course not impossible, but the least likely option I see. ?

Personally, it would help me a bit at home too. My wife is generally well versed in financial markets and has begun to question my continued claims regarding how unique, challenging, shocking, exceptional, and volatile this year has been. Not dissimilar to my curiosity how it is possible that every single one of my daughter’s swim practices have been the hardest ever!?

In any case... while the macroeconomic conditions may continue to price some uncertainty – bonds have returned to prevalence, offering reasonable return potential and ensuring fixed income should find its way out of the doghouse and back into the home!?

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Congratulations on making it to the end - I hope that you found this piece enticing and educational... As market opportunities continue to evolve, many have begun to take?comfort in the stability and substance found in fixed income assets. While market volatility remains elevated, from this piece we can see that often from the darkest nights emit the brightest lights. From our viewpoint, the path ahead, while not risk-free, appears increasingly enticing. ?

As a closing note, I hope?my American readers have a Happy Thanksgiving!?

If you have any thoughts, comments, or questions - please reach out.??

All the best,??

Konstantin?