In the meantime, we are cautious in our asset allocation in the face of risks of profit slowdown. Do bonds offer the ability to protect investors against economic and equity market turbulence? The answer is that it depends. If inflation continues to be stubborn and remain higher for longer, then the risk is that bond yields could remain at current levels and even move higher. This could be a repeat of 2022, when inflation and interest rate volatility caused bonds to lose value, resulting in pressure on equities. If inflation falls back towards Central Bank targets, then bonds may once again become the ballast in portfolios.
If Central Banks drive economies into recessions to generate low inflation, then bonds may generate positive returns to offset the equity market losses likely in an economic downturn. The ability of bonds to diversify against recession risk – rising in price when equity prices are falling – is now also much stronger.
While it is not our base case, if the global economy did fall into a deep recession in 2023, investors would likely flip quickly from worrying about inflation to worrying about deflation. In this scenario, bond yields would have significant room to fall from current levels. If 10-year US Treasury yields fell by 2%, this would deliver a return of close to 20%. This is the kind of meaningful diversification against equity losses that multi-asset investors rely on when constructing balanced portfolios, which has not been available for several years given the very low level of yields.
But the bonds to own need to be of the highest quality and not subject to the risk of credit default.
Springs warm up but markets feel cold
Inflationary pressures appear to have peaked. This remains the case, but the move back to low inflation may take longer than previously anticipated in the US as the housing component is likely to remain higher for longer. Markets have reacted to this by increasingly thinking that the Federal Reserve will hold interest rates higher for longer.
Given the backdrop of challenging interest rates and declines in earnings expectations the outlook remains a challenge for optimistic risk takers.
Whilst there are a mix of signals from competing asset classes, we are looking into 2023 for clues to become more positive.
A key indicator will be a trough in profit margins. That still feels to be distant. High quality assets may prove key to withstanding equity market volatility.
All expressions of opinion reflect the judgment of Artorius at 15th March 2023 and are subject to change, without notice. Information has been obtained from sources considered reliable, but we do not guarantee that the foregoing report is accurate or complete; we do not accept any liability for any errors or omissions, nor for any actions taken based on its content. The value of an investment and the income from it could go down as well as up. The return at the end of the investment period is not guaranteed and you may get back less than you originally invested. Past performance is not a reliable indicator of future results. Nothing in this document is intended to be, or should be construed as, regulated advice. Artorius provides this document in good faith and for information purposes only. Reliance should not be placed on the information contained within this document when taking individual investments or strategic decisions. Artorius Wealth Management Limited is authorised and regulated by the Financial Conduct Authority. Artorius is a trading name of Artorius Wealth Management Limited.