Amid optimism that inflation has likely reached its peak in the US, now is a good time to consider adding duration – or interest rate sensitivity – back into investment portfolios, says Zenith Investment Partners Investment Consultant, Calvin Richardson.
Richardson says that after a torrid year of persistently higher inflation prints, it is refreshing to hear some optimism that inflation in the US had likely peaked.
This view was subsequently confirmed, at least in the short term, by the US inflation numbers finally surprising to the downside. This has seen the annual rate of inflation decline to 7.1% in November, which is down sharply from the 9.1% peak achieved in June.
Despite remaining uncomfortably high, markets are intent on buying any suggestion that inflation has peaked and that the path of interest rate hikes will moderate. This was on display when the October print was released and the tech-heavy Nasdaq soared 7.4 per cent in one day.
Richardson adds that among the varied discussions he’s had with portfolio managers around inflation and fixed income markets, the common theme is a move to add duration – or interest rate sensitivity – back into portfolios.
"An improved global economic backdrop over the past 12 months has produced a powerful rise in inflation. Consequently, central banks have responded by aggressively increasing interest rates to choke off demand within the economy, which flows through to higher bond yields,” he says.
Higher bond yields have a contractionary effect due to higher borrowing costs for individuals, governments and businesses which then discourages investment and spending.
Due to the inverse relationship shared between yields and the capital value of bonds, this has prompted bonds to reprice heftily lower.
Richardson says Zenith’s portfolios have been intentionally positioned with lower duration than the benchmark, resulting in a more subdued pullback for its investors’ fixed income allocations.
Following a period of strong outperformance from this stance, we’ve recently moderated this positioning in light of the newly attractive bond yields available.
"The washout in fixed income markets, while painful, has led to the normalisation expected to unfold over a longer period. This has dramatically reinvigorated the defensive qualities associated with fixed income due to the higher starting yields, which makes the asset class significantly more appealing for us,” Richardson says.
Furthermore, should we enter a recession where interest rates are cut, having more interest rate sensitivity means that the value of our bonds will rise and the negative correlation between bonds and shares should reassert itself.
Richardson also notes there is division among fund managers regarding the outlook for private assets, given investors’ erroneous perception that they offer greater safety versus their publicly listed counterparts. He says this misperception stems from the reduced volatility associated with private assets due to their illiquidity.
“The primary difference comes down to how the two are traded, with publicly listed securities offering liquidity on a public exchange, such as the ASX200, whereas private assets are exchanged infrequently between two or more private counterparties,” he explains.
This is particularly topical given the scrutiny around the performance profile of our local industry super funds, with question marks around the lack of write-downs to date on their private assets.
Naturally, there was no consensus on whether the private market values would catch-down to their listed market equivalents, or whether their run of outperformance would be sustained.
However, in-line with our views was the increasing importance of alternatives in portfolio construction to deliver uncorrelated and differentiated return streams to buffer the broader market volatility.