‘Maximum convexity’ might be a contender for the next Bond movie if Arif Husain, T Rowe Price head of fixed income, is right.
Husain told Australasian investors in a presentation last week that global fixed income markets are probably at the point where dramatic tension tips over into frantic action.
“When you’re at the point of maximum convexity, all that is saying is, we’re in an unstable equilibrium. Something has to happen, we’re either going to rip – like the 2008 meltdown in credit markets – or we get a big, big rally and a big correction,” he said. “My view is because of the liquidity situation and the quantitative tightening situation it probably looks more like 2008… but the opposite scenario is still very likely, you can get a massive rush for income.”
And fixed income investors need to be ready for either extreme, Husain said, as the fundamental market change – triggered by inflation, rising rates and vanishing liquidity – takes hold.
For example, he said bond managers must remain “nimble” in managing credit exposures on both the long and short side in anticipation of a renewed default cycle.
But as well as more sustained volatility, investors also have to navigate an unsettling change in asset class correlations that has seen bonds and equities move in lock-step this year, trashing the reputation of the traditional 60/40 portfolio in the process.
“… we all end up being asset allocators; we all want to put different assets together to end up with a better combination. The best players don’t necessarily make the best team, that’s the way we generally think about it,” Husain said. “And correlations having moved from negative, which is where we want them to be, to positive.”
“The research we’ve done suggest that if core inflation stays above, say 3 to 3.5 per cent, then we will not return to those negative correlations for a long period of time.”
He said the alignment of equity and bond markets is directly related to the shift from the easy money era to the new reality of quantitative tightening (QT).
According to a T Rowe Price analysis, stimulus has now turned negative following a post global financial crisis liquidity boost that floated all asset prices higher in subsequent years.
Indeed, the combined monetary and fiscal kitchen sink effort kept assets rising between 1 to 3 per cent each year until briefly hitting neutral in 2019 before spiking to a peak near 6 per cent as COVID emergency liquidity hit financial markets.
“We have gone from a world of quantitative easing, to quantitative tightening,” Husain said. “And that simple one factor model explains pretty much everything that you need to know.”
He outlined a number of strategies fixed income managers can employ to mitigate the three key risks of rising yields, market volatility and unstable bond-equity correlations including: long-short positioning; active duration management; hedging arrangements; and, diversification across countries and credit.
Overall, investors have “to be smarter about how we think about diversification, how we all build our portfolios”, Husain said.
The flexible approach to portfolio management has seen the T Rowe Price Dynamic Global Bond Fund weather a tough year for fixed income, he said, posting an after-fees return of almost 7 per cent for the calendar year to September 30 versus the benchmark 0.51 per cent.
In a world where maximum convexity is coming to a market near you soon, however, Husain said the “big takeaway… is you’ve got to be acting differently, you’ve got to do something – doing nothing is a very dangerous outcome, as we saw in the returns in fixed income assets over the last year or so.”