Fixed income investors are being forced to find returns in new places, as they adapt to the reflationary environment emerging in the wake of the policy response to the pandemic.
In short, it has pushed investors to incur higher risk in their search for returns.
“Higher growth and inflation will see yields rise and so a more ‘absolute return’ approach will be needed to achieve positive returns in the fixed income space,” said Mark Nash, fund manager, fixed income, Jupiter Asset Management, at the recent FSA alternatives event.
Investors should take short positions – either outright or for relative value investments. They will also need to be flexible to invest across the fixed income universe to find return sources, he added.
In line with this, the traditional role of high quality bonds in offering diversification and protection is changing.
“In this context, gold has increasingly gained acceptance among a wider set of investors – from individuals to institutions,” explained John Reade, chief market strategist at the World Gold Council.
The asset class is increasingly used as a diversifier, as well as to tackle tail-risk and inflation. “The low interest rate environment has reduced the opportunity cost of holding gold as a strategic asset,” he said.
Making a different approach count
Policymakers appear to have learned from errors following the financial crisis in 2008 – an era marked by low growth, low inflation and central bank dominance.
Today, as the global economy rebounds from the pandemic, fiscal spending looks unlikely to disappear anytime soon while inequality and global warming issues are addressed. According to Nash, central banks will remain supportive but trough more of a back seat, as long as banking systems are healthy enough to support recovery.
Yet current market dynamics make it more challenging for traditional funds to make positive returns.
“If the recovery falters and there’s a slide into deflation, then the risk is that more duration-heavy funds would perform better,” said Nash.
However, he is confident his strategy can take market directional positions and look to keep pace with long-only strategies in a falling yield environment. “A key part of the process is the team’s study on market price action to more accurately market time the implementation of medium-term strategic views.”
A highly liquid portfolio can also help investors maintain flexibility in changing strategy or reducing risk quickly and cheaply, if necessary.
Weighing gold allocations
In the case of gold, meanwhile, its ability to help investors capture some of the upside as economies recover, plus protect the downside is underpinned by its dual nature as an investment and a consumer good.
“More than 40% of net annual gold demand is linked to jewellery and electronics, and thus positively linked to economic expansion,” Reade explained. “Conversely, investment demand, which also accounts for more than 40% of net annual demand, tends to be countercyclical and protects portfolios in periods of economic uncertainty.”
Yet gold can also be sensitive in the short term to interest rates and the overall direction of monetary policy.
As a result, tighter monetary policy will likely create headwinds for the asset class. “In the end, the magnitude of these headwinds will depend on how other variables such as inflation concerns or currency debasements impact investor decisions,” said Reade.
At the portfolio level, however, gold is a well-established hedge against tail risk. “As a high quality, liquid asset, it can help investors mitigate the impact of significant pullbacks in the stock market,” he added.
The asset itself can experience volatility and is not immune to price changes. To manage gold allocations more effectively in expectation of potential headwinds, some investors therefore tend to use options strategies, said Reade.
To find out more about the strategies that were covered at our Spotlight On: Alternatives, see links below.
