This is a sponsored article from Natixis Investment Managers.

True macro specialists, DNCA Investments discusses the new paradigm for fixed income investors and how flexibility and true diversification will make all the difference.

Shifting economic winds

Is the “great moderation” and 40-year bond bull run nearing its end? DNCA, an affiliate of Natixis Investment Managers, believes it is already finished, with the 2020 lows in government bond yields – which saw the US 10-year fall to 0.5% while European government bond yields were deeply negative – marking the low.

“Consider the tectonic changes afoot: fiscal dominance, deglobalisation, increased geopolitical tensions, resource constraints, and the nascent green transition. All are likely to put upward pressure on inflation and, with that, increase rate volatility going forward,” said Francois Collet, portfolio manager and deputy CIO for fixed income.

Fiscal spending was not an issue after 2008 when governments embraced austerity and central banks used monetary policy, including buying government bonds, to try to stoke inflation and growth. Now, the opposite is true, with governments running wartime deficits when unemployment is near record lows.

Deglobalisation, meanwhile, is a relatively new phenomenon that should continue. Of course, geopolitical tensions, be they in Ukraine, Taiwan, or the Middle East, could escalate in the coming years, threatening vital supply chains.

“Given this, we would not be surprised to see inflation settle at a higher level than before and for inflation volatility to remain higher,” said Collet. “And you are already seeing this in some indicators like long-term inflation expectations and, more recently, a persistent bid for hard assets like precious metals and other commodities.”

Higher inflation, greater volatility?

Higher inflation volatility has profound investment implications. First, if central banks are serious about keeping inflation at around 2-3%, Collet added, then their reaction will have to be more aggressive and more often to tame inflation when it rises above 2-3%.

“That’s obviously bad for nearly all assets as they drain liquidity and tighten financial conditions like 2022,” he said.

Second, if inflation is less certain and more volatile, bond investors are likely to demand higher term premiums for holding longer-dated bonds, while yields are likely to spike higher on occasion.

“In very simple terms, this could weigh on government bonds, steepen yield curves and hurt equities – whose valuations are discounted against local government bond yields and the ‘risk-free rate’,” Collet said.

This was seen briefly in 2023, when the US government’s aggressive fiscal policies caused the term premia to spike, hurting equities. In 2022, an oil price shock propelled oil prices and yields higher. Both remain serious risks going forward, according to Collet.

What does this mean for investors? Get active and diversify

“In blunt terms, the 60/40 portfolio is coming to an end,” Collet argued.

He explained that such a portfolio and the idea that stocks and bonds will always be inversely correlated are relatively new phenomena.

If you look back throughout history, and especially when governments have targeted the real economy and economic growth, this has typically not been the case. In 2022, the number one diversifier for investors was actually oil, and energy was the only sector that posted positive returns that year.

The same can be said for fixed income. While DNCA’s cash-plus flexible bond strategy fared very well due to its ability to shorten duration or even short longer duration bonds outright, most traditional fixed income funds do not have that luxury.

“This is what makes us different, and we take a highly diversified approach that aims to develop multiple alpha sources for our fixed income portfolios. We think traditional fixed income will continue to struggle and may not offer the ballast or defence that it once did, and which investors still need,” Collet added.

A new bull market for nimble fixed income investors

“With the right expertise, volatility can be turned from a foe to a friend,” Collet continued.

“The 40-year bond bull market may be ending, but with the help of strategies like duration management, arbitrage, relative value etc., we believe a new bull market for nimble and intelligent investors is just beginning.”

To learn more about DNCA and its differentiated fixed income investing approach, click here.
 

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This is a sponsored article from Natixis Investment Managers.