This certainly proved to be the case in calendar year 2016. The pro-bond and ‘safety asset,’ growth-pessimistic environment of the first half of the year reversed sharply in the middle of the year – well before Trump.
The big issue for investors from here will be whether this reversal was simply the unwinding of a short term episode or the starting point of something more profound; a genuine shift in the multi-year and even multi-decade return environment.
This week, and last year, Tony wrote about how the high starting point of yield and the structural decline in inflation and interest rates since the 1970s set investors up for a multi-decade period of government bonds delivering returns more commonly associated with more volatile assets.
This intensified with the financial crisis and supported investors who, mentally scarred by that experience, had an obsession with minimising volatility and drawdown. As Tony noted this week, the result has been an environment in which being cautious has actually been rewarded.
Many who have held assets for their ‘safe haven’ properties have instead been gifted with ‘growth-like’ returns. This has made it easy for even traditional static multi asset allocations with high bond weightings to look like deliverers of ‘risky returns without any risk.’
The second half of last year was a challenge to these strategies, as some bonds displayed higher volatility and even some sharp losses. Investors who panicked amidst the recession fears of January and February, or fell into the trap of forecasting in response to the Brexit vote or Trump’s victory often compounded these problems.
It remains to be seen if 2016 marks the beginning of what we believe could be a significant multi-year change in regime. No doubt such a transition would not be a smooth one, and will be subject to extreme periods of relapse. Significant structural shifts cause huge confusion in markets, and I fully expect to have this argument laughed at over the coming years.
How does this view on a pivotal moment differ from a forecast? Importantly, it is built on what I am observing today: the late-cycle ‘blow off’ nature of the bond rally in H1, capitulation in beliefs, and extreme growth pessimism which set markets up for a surprise. This is combined with macro improvement and challenges to the policy regime, of which Trump is just a symptom.
Most importantly, from an investment point of view you may not need the structural shift to materialise to win. Even if the regime does not change, prevailing valuations suggest there is little more return to be generated from a structurally bullish view on inflation and interest rate trends, while the compensation on offer from more volatile assets still looks compelling.
In the meantime, shorter term volatility will also provide opportunities for disciplined investors. The key is to stay focused on big issues such as regime in order to know how best to respond in such testing moments.