Three things that have surprised me – and one thing I wouldn’t change

Nov 18, 2021

Over the past 18 months, we’ve all learned a thing or two while adapting to quarantine life. I, for one, mastered using a headset designed for professional gamers on work calls, while also using time I had previously spent on the Metro-North figuring out how to grow vegetables in Connecticut.

In financial markets, investors have had to do some adapting as well. Equities are back to all-time highs, inflation is jumping higher, the political and regulatory climate is a source of uncertainty, and an unprecedented amount of liquidity in the system alongside huge global demand for high quality bonds has pushed yields to rock-bottom levels.

In a way, the last 18 months haven’t been entirely different from the last 10 years of managing diversified income portfolios. The market ebbs and flows, but ultimately drives higher over time. But there are a few things that have surprised me over the decade I’ve managed the Multi-Asset Income Fund that will likely shape how we think about finding attractive income and returns in the next decade.

First, back in 2011, I would have never thought the Fed’s zero interest rate policy would still be in place 10 years later. Furthermore, it’s pretty wild that we have record equity levels and strong global growth coming out of the pandemic, yet the 10-year Treasury yield sits about 40bps lower than the 1.97% level when we launched the fund. And even looking ahead to the 10-year forward curve today, the market’s predicting the 10-year yield will be at 2.3% in five years – certainly not what many investors thought a decade ago. We’ve run big deficits, more than doubled the market value of outstanding Treasury debt, and yet the market views the growth outlook as stubbornly fragile.

Market expectations for interest rates remain muted

Chart image

Source: Bloomberg as of November 8, 2021. 10-year, 5-year forward curve represents market expectations of the 10-year US Treasury yield looking forward 5 years.

So, what does this mean for investors? Don’t expect much from core fixed income in the years ahead. There has been a close historical relationship between starting yields and forward-looking returns. Meaning, if the market believes the 10-year Treasury yield is still only at 2.2% in 5 years, you’re unlikely to expect much more than that in total return from core bonds. This is why we continue to embrace areas like high yield bonds, bank loans, high quality dividend stocks, and covered calls. This diversification and willingness to take more risk in search of income and returns may be more crucial going forward than it has been the last 10 years

The second thing that has surprised me is the outperformance of the U.S. over Europe. While I thought U.S. equities would lead, the S&P 500’s more than 350% return over the last ten years easily beats the EuroStoxx’s roughly 125% move.* Throwing emerging markets into the mix gives an even more pronounced picture – broad emerging market stocks (as measured by the MSCI Emerging Market Index) are up roughly 70% over that time, with most of that return coming from dividends, not price movement. While this level of outperformance going forward may not be sustainable, I think it tells investors that winners can continue winning, even in the face of elevated valuations and myriad of headwinds and uncertainties they may face. Does this mean equity diversification is dead? No, quite the contrary, as some of these losers may transition to outperformers moving forward. But it does highlight the diversified nature of the U.S. market and its ability to outperform over time.

Third, yields across virtually all fixed income sectors have experienced a tremendous drop – one I didn’t necessarily think was possible. For example, the average yield on high yield bonds (represented by the BBG US HY 2% Issuer Cap TR Index) has gone from ~9% to around ~4% today. Investment grade bond yields (represented by the BBG US Corp Bond TR Index) touched an all-time low of ~1.7% and today don’t sit much higher. Why is this important? With inflation running hotter, the real yield on virtually all high-quality bonds is negative. Furthermore, a record level of bonds are now rated triple-B – the lowest grade to qualify as investment grade. This is a sign, in my opinion, that investors are not getting compensated for the risk they are taking. While we’re not calling for a massive threat to high quality bonds, we’re simply pointing out unless investors are willing to take a bit more risk within their fixed income allocations, there is a significant risk the yield won’t even offset inflation in the years ahead.

The short takeaway from these observations is that delivering attractive investment outcomes may be more challenging and more complicated moving forward. Which leads me to my last point – one thing I’ll never compromise despite trickier market dynamics: a risk-first approach.

In the Multi-Asset Income Fund, we’re investing in both traditional and less conventional assets to help to deliver competitive income and attractive risk-adjusted returns. We’re willing to own riskier asset classes, we’ll actively move the portfolio around, and we won’t be immune to market risk. But we’re always thinking of how the average income-oriented investor is seeking steady, consistent results without undue risk, and that’s exactly how we manage the fund. 

In many ways, the last 10 years were a time of profound change for the financial system, during which many of the conventional wisdoms of investing were up upended. We’ve had to adapt but we continue to uphold our responsibilities to our investors, understanding their financial goals are the same and more important than ever.

<h2>Michael Fredericks</h2>
Portfolio manager, Head of Income Investing for Multi-Asset Strategies & Solutions