As we move into a new year investment sentiment is riding high, in fact it’s so high it’s a good time to ponder astute investor Warren Buffet’s famous quote: “be fearful when others are greedy”.
Positive sentiment in the market is generally considered a good thing. However, the levels of market euphoria is at highs not seen since just before the 2001 dot.com crash. The levels can be measured using metrics like credit spreads and put-to-call-ratios.
Is a market correction on the cards?
In such market conditions people tend to buy stocks with lower regard to underlying fundamentals, and that increases the chance of a market correction. Looking back over such events historically, we have concluded there is a 70 per cent chance of an eight per cent correction.
It’s the type of activity that draws the attention of informed investors, and it is driving a reaction from ‘smart money’ as it is diverted to create buffers against any correction. Smart money typically flows to long term interest rate markets, including instruments like US 10 year treasury bonds and commodity future trades in metals like copper and iron ore.
Reflation or inflation?
Currently activity in these markets is telling us that for the first time in a very long period, inflation is being taken into account by long term investors. It is now up to policy makers to ensure that inflation does not become an issue, and that we go through a sustained period of reflation.
So far we are on the right track. Reflation is the attractive cousin to inflation. It means growth companies outperform as economic activity expands, and this leads to improved employment and productivity.
Reflation is the intentional release of controlled inflation through policy, it can include low interest rates, increase in money supply, infrastructure spending and tax cuts. Deployed correctly it leads to a gradual rise in interest rates in a manner that doesn’t derail growth.
Rate defying bond strategies
In an inflationary environment bonds can also defy the typical scenario of underperforming in a rising interest rate environment. While rising interest rates do impact bond returns, what matters most is the pace at which rates rise.
In a gradually rising environment bond holders have the opportunity to sell out of shorter duration bonds and move into higher yielding bonds, providing a better long term return.
One thing to keep in mind for investors that do shift to longer duration banks is timing. For instance, the Reserve Bank of Australia has telegraphed it is committed to keeping cash rates near zero until 2023. Therefore, investors that buy a medium duration bond (5-7 years) will end up with a short duration bond by the time we see rate hikes.
The certainty created in a slow rising rate environment is soothing for investors. In comparison, in 2018 we saw equity markets sell off in a ‘taper tantrum’ due to fears the Federal Reserve would begin to raise rates.
This was following four rate hikes and the expectation of two more hikes, which did not materialise.
Keeping a level head
A reflationary environment is very different and is in fact likely to lead to further market gains, as long as inflation doesn’t get out of hand. While we may see gradual rate hikes in the second half of 2022 in the US, it is too early to call given that unemployment and growth are hard to see from where we stand today.
Markets continue to try to price in something they cannot see, and while the rise in treasuries is painting one picture, it may just be markets ‘jumping at ghosts’. There is still too much uncertainty around the rollout of vaccines and the potential for future lockdowns in the US which could lead to a double dip recession.
Rather than making assumptions on these matters, investors can peruse prudent hedging strategies that will allow them to stay invested but maintain a downside hedge.
Investors should also remember that long term interest rates are not always easy to predict, so while US 10 year rates going up today could be reversed if there is a slowdown in the recovery, which would push bond prices back higher. Investors should work with their relationship managers to best navigate this environment.
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