Bond markets are in a new regime – ‘safe havens’ are no longer acting as such, and investors can no longer expect asset classes to behave as they have done historically. As a result, asset allocation approaches need a reboot, and portfolio diversification has never been such a virtue. Peter Kent, Co-Head of Fixed Income examines this in his latest paper, Reframing fixed income: the old rules are no longer fixed.
1. A blurring of lines – The line between emerging and developed markets (EM and DM) is blurring, with traditional ‘safe haven’ debt markets now in a new (higher) volatility regime. Since 2022, returns have been lacklustre in DM bond markets, while EM debt has shown surprising resilience. Crucially, while volatility in the EM bond market has remained within its historical ranges, in DM it has risen sharply.
Episodes of bear steepening in DM yield curves reflect concerns around policy credibility – this is a phenomenon that’s traditionally been reserved for EM bond markets. In the context of the risk/return equation, as the volatility of asset classes traditionally viewed as risk-free (e.g., UK Gilts and US Treasuries) has shifted gear, higher returns are now required to replicate past experience.
2. A world order turned on its head – labels typically associated with EM economies have become increasingly common descriptions for some of the world’s most ‘developed’ economies.
Credible policymaking and fiscal reform are unmistakable trends in EM economies and these fundamental improvements are fuelling positive credit-rating dynamics. In contrast, a common theme in DM economies in recent years is a deterioration of macroeconomic fundamentals. Here, too, a less predictable policymaking backdrop equates to a more uncertain macroeconomic outlook, necessitating increasing caution by – and risk premium for – investors.
3. Debt’s defensive properties under question – the shifting nature of economic shocks has profound implications.
In addition to entering a new volatility regime, DM debt has also seen its role as a defensive portfolio allocation put to the test. The shift from demand to supply shocks has changed the nature of interest rate risk and its relationship with risk assets, meaning it’s not as helpful for managing a balanced portfolio as it used to be.
4. A major headwind to EM assets is retreating – the US dollar unlikely to follow the same path as the past decade
While the US economy has dominated global growth in recent years, the investment and inflation outlook for the next decade is likely to mean a more even distribution of nominal growth across the globe. The US dollar strength that has prevailed over the past decade, casting a shadow over EM asset-class returns, is arguably fading. EM debt deserves to move back onto asset allocators’ radars.
5. EM Debt as a Diversifier – The case for portfolio diversification has never been stronger, but the means have changed.
Shifts in asset-class behaviour, coupled with the changing nature of economic shocks, mean the case for portfolio diversification has never been stronger. A ‘far and wide’ approach may be needed when diversifying. And this is not just about picking winners; it’s about avoiding losers, especially in today’s geopolitical reality.
In this context, it is important to recognise the usefulness of EM debt as a portfolio diversifier, given the varied behaviour of individual asset classes across the cycle and the large dispersion across markets that sit within these.
