A bond market reminder of market fragility

Whether interest rates keep rising will have a lot to do with the inflation outlook. If Reserve Banks across the globe become concerned that inflation is out of control they will raise interest rates. The current inflation spike is beginning to look a bit less transitory, but market consensus continues to assume inflation will ultimately fall away. Inflation becomes persistent when employees start expecting regular wage increases. There are signs of that. There has been regular reporting in New Zealand and abroad of labour shortages, and of an increased appetite of employees to consider an employment change, being dubbed the “Great Resignation”.

A recent survey by McKinsey found that forty percent of employees surveyed in Australia, Canada, Singapore, the United Kingdom, and the United States were at least somewhat likely to quit in the next three to six months. They also found that most employers were experiencing greater turnover than normal and most expected the problem to continue or worsen over the next six months. There appear to be many reasons for this, but primarily employees must see themselves in a strong bargaining position. This has not been the case for a long time.

If interest rates continue to rise, there will be plenty of investments to avoid. Traditional balanced funds look vulnerable, in our opinion, because of their high exposure to low yielding bonds. There will also be plenty of blow-ups. Risk-parity and volatility targeting strategies are, in our opinion, ones to watch here. In a traditional balanced strategy you increase your expected return by increasing your exposure to growth assets, predominantly equities. As a result, the higher your expected return, the higher your exposure to equity risk. The goal of risk parity is to build a diversified portfolio where each group of assets contributes an equal amount of risk so that the return is not primarily determined by equities. However, these strategies are essentially leveraged bond portfolios with some equities. And imprudent leverage can result in permanent loss of capital, even if the underlying asset is relatively safe. There is a lot of money invested in these strategies. Estimates vary, but total assets under management in strategies that respond to risk inputs could be over 1.5 trillion US dollars.

Our economic future is still very much up to the policy makers. Where inflation and interest rates might go remains highly uncertain. But expect some bumps along the road, and, as the recent bond drawdown showed, some of them will be big ones.