Posted inAsset managers

Duration to help portfolios weather downturn

As recession risks grow, investors should consider adding duration to their portfolios, according to Fidelity International.

Tough action by major central banks around the world to fight inflation has the potential to result in the type of excessive stress on the economy that greater exposure to US Treasuries can help mitigate in investment portfolios.

In short, if recession risks do grow, then duration is likely to perform well, believes Fidelity International.

“It could make sense to gradually increase exposure to US Treasuries as we think that growth concerns will start to dominate inflation concerns as hard data turns,” said Steve Ellis, the firm’s global chief investment officer for fixed income.

Adapting to a risk-off climate

Although 2022 has so far been a difficult year for risk assets, investors should not automatically extrapolate the current environment into the future, warns Fidelity.

Since economic conditions can and do change, the firm believes investors may see both growth and monetary policy shift sooner than the market expects.

“Central banks rarely succeed in tightening monetary policy without triggering an economic downturn,” explained Ellis. “At present, markets expect lofty increases of 150 to 250 basis points in benchmark interest rates in the US, Europe and the UK over the coming 12 months.”

In response to the mounting pressure on central banks to rise to the challenge of bringing inflation under control, he added that further selloffs in equities and a widening of credit spreads are possible.

The latest upsizing of the US Federal Reserve’s hike to 75 basis points – the first time it has done so since 1994 – is an important development on this front.

“However, the stress on the economy could be greater than many think,” said Ellis. This is based on financial conditions tightening rapidly and liquidity draining out of the system. “This is just as Fed quantitative tightening is starting.”

Tackling tricky conditions

As a result of these dynamics, he suggests there is a real possibility that the major central banks will have to abandon their tightening trajectories prematurely – given the fiscal cliff, powerful base effects, a significant loosening of the labour market, a swing down in housing market and thawing supply chain issues.

“If that’s the case, the narrative in the market could shift abruptly and wrong foot investors,” added Ellis.

He sees the risk of further asset price dislocation being skewed to the downside and credit markets still under-pricing corporate defaults that would quickly rise in a recessionary environment.

For example, the one-year implied default risk for US dollar-denominated high yield is approximately 2.5% – which Ellis considers to be far too optimistic in the face of a rising rate and slowing growth backdrop.

“Capital preservation in a climate of heightened uncertainty is essential, however, when monetary policy and the market narrative change eventually, there could be exceptional returns available,” said Ellis.

Part of the Mark Allen Group.