We have long held the view that in the latter stages of an economic cycle it is wise to have a reasonably large and strategic allocation to ‘risk free’ rates, while having enough ‘good’ duration to balance the portfolio and mitigate volatility. Such a rates allocation will detract from yield, but should exhibit capital appreciation in times of stress.
Entering 2020 we thought the main risks facing fixed income investors were geopolitical, in particular a re-escalation of the trade war that had weighed so heavily on business confidence during 2019. We reasoned that a re-escalation might cause risk assets to pause their rally, perhaps stimulate the Fed into additional rate cuts, and certainly provide impetus and rationale for a strong rally in US Treasuries.
None of us had contemplated the outbreak of a new coronavirus, but the result has been similar, particularly in regard to the performance of ‘risk free’ assets; both five- and 10-year USTs rallied by around 40bp between January 1 and month-end.
While we are all now debating how the outbreak might impact certain industries and companies, the direct effect it will have on the Chinese (and by extension the global) economy, and whether it will prompt central bank action, we should also remain vigilant to the vulnerability that Treasuries now have to a recovery. History shows that the impact of such events tends to be V-shaped, as GDP growth quickly bounces back once order has been restored. Therefore the dip in Treasury yields is likely also to be V-shaped, unless of course another driver steps in to maintain the fear.
So, while on one hand we would want to be strategic with a meaningful allocation to ‘risk free’ rates – which for us in recent months has been US Treasuries – on the other hand we should recognise the gains investors have made on them year-to-date could be given back.
Perfect timing is practically impossible in situations like these, but one way to tackle this risk is to gradually reduce ‘good’ duration by moving to the shorter part of the UST curve, which would be less sensitive to a move higher in yields. This move would be purely tactical, and seems logical, but even with a strategic risk-off position it is important to be prudent and pragmatic, as other surprises can happen and we remain in a mature phase of the credit cycle.