Stagflation threatens safe haven of long-term sovereign bonds
CAUTIOUS investors are buying US and European sovereign bonds even though inflation remains stubbornly high.
History has shown that when markets become volatile and uncertain, investors switch funds into what they perceive to be safe haven assets. Indeed, since the 2023 banking crisis began in March, US$24.5 billion has flowed out of equity and risky high yield junk and emerging market bonds into US Treasuries and other government bonds, according to data from Refinitiv Lipper.
But the big question is whether developed nation sovereign bonds are a safe investment in an economic environment of stagflation, notably high inflation and low growth.
Several portfolio managers and asset allocation strategists put forward a cogent bull case for sovereign bonds but warn that corporate and emerging market bonds could be risky in an economic downturn.
Banking problems and “significant tightening of credit conditions could cause a deep recession” in the US, Europe and other parts of the world, contend Erin Browne and Emmanuel Sharef, portfolio managers at Pimco, a US$1.8 trillion asset manager.
Puzzled that equity markets have remained resilient, they maintain that “equity valuations appear rich across every metric we track” and that investors should diversify into quality bonds.
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“Central banks are fighting yesterday’s battles as a credit crunch looms,” cautions Salman Ahmed, global head of macro and strategic asset allocation at Fidelity, an asset management firm. “The tightening delivered by the Fed and the European Central Bank (ECB) is already sufficient to cause a recession.”
“The real economy in the euro area is yet to face the hit, but it is coming,” he warns, adding that investors should be “overweight in government bonds, underweight in corporate debt and remain neutral on equities”.
US, European Union and UK economists agree that the banking crisis will cause tighter loan standards and higher mortgage and credit card costs for consumers. This credit contraction will lead to recession, they say. The Bank of England (BOE), which raised interest rates by a quarter percentage point to 4.5 per cent last week, contends, however, that a UK recession is unlikely.
Stubbornly high inflation – currently 10.1 per cent – implies that interest rates are likely to rise further, notes Adam Hoyes, a markets economist at Capital Economics, a UK consultancy firm. Despite that, Hoyes is recommending gilts – UK government bonds – as he expects inflation to fall and the UK economy to contract.
The US, with some US$51 trillion of bonds outstanding, including US$27 trillion government bonds, is by far the biggest fixed income market in the world and will determine global trends, according to Pimco. The 10-year bond yield of 3.41 per cent is lower than the 2022 high of 4.1 per cent and well below the Federal Reserve’s current rate of 5.25 per cent. German, French and UK 10-year bond yields are also below bank rates.
In bond market jargon, this is an inverted yield curve. Normally, the yield curve slopes upwards – that is, yields of bonds due to be repaid in, say, 10 or 15 years are higher than yields of bonds due to be repaid within months or between one and three years. Two-year US treasury bonds, for example, are yielding 3.99 per cent, well above the 10-year yield.
In a strong economy, long-term bond yields tend to be higher as growth and inflation are expected to rise. But when investors are prepared to pile into long-term bonds and push their yields below short-term bonds and bank rates, they believe that economies are sliding towards recession.
The problem with stagflation, however, is that the inflation beast, which is difficult to control, raises the risk of bonds. It is safer to buy a short-term bond, as the longer the life of the bond, the greater the price fluctuation. The surge in bond yields last year led to huge losses.
Traders recall investors who had thought 10-year US Treasury bonds at 2 per cent were good value. But the yield rose to a high of 4 per cent and the paper loss on that bond was 16 per cent. For the same yield increase, the loss on a 15-year Treasury was 24 per cent.
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