Overview
Safe havens will be safe until they’re not. The last few months have made that patently clear. There might be ‘safer’ places in markets, but these in turn will depend on circumstance and, at a time when a number of arguably structural shocks are being applied to the world economy, the identity of those destinations for capital is liable to change.
That’s the subject matter of the latest episode of the Fidelity Answers podcast, with bond fund managers Mike Riddell and Tim Foster seeking to answer the question of how to balance capital preservation with investment returns at a time of heightened doubts about geopolitics and its impact on the global economy. The role of US Treasuries and the dollar, principally, has come into question.
“Clients are really thinking about their Treasury exposure, their exposure to the US,” says Katie Roberts, a guest host on this month’s episode and who as head of client solutions at Fidelity International talks to big institutional investors every day. “Where do I go for those defensive assets? And also, where do I go for my diversification? Ultimately people want something that's boring and they haven’t been getting it from bond markets.”
Fiscal pressure
At the heart of the discussion are worries about the longer-term prospects for the United States’ public finances and, this year, the sheer scale of issuance it has to get through at a time when investors’ commitment to US markets has been questioned. After New York stocks sold off in April, the money did not naturally flow back into bonds, and Treasuries didn’t provide the security people would normally expect.
Foster argues this was confined to a handful of days in April but he says the problem is that, at the margins, investors have grown used to finding safety more in shorter-dated US government bonds than in paper dated 10-years and above.
“Demand for longer-dated bonds has been waning,” he says. “If when people say safety, they mean safety from some recession or crisis, short-dated US Treasuries will be the safe haven.”
For many, however, the changes brought about by President Trump’s tariff and trade policy raises a bigger issue. In trade-weighted terms, the dollar has been on a constant upward path since the aftermath of the 2008 crisis and if that trend is finally turning, there’s a long way to fall.
“The dollar has had a step change,” says Riddell. “We have had 10 or 11 years of hundreds and hundreds of billions of dollars of assets going into the US dollar, and people who didn't hedge are now getting very worried.
“I've had conversations with clients in the last few weeks, whether it’s a Swiss private bank, London councils, or all sorts of other clients who are investing in US assets. All of it has been unhedged, which has been a great trade, and everyone is now worried about it.”
That points to a wave of money that could potentially turn against the greenback in the months ahead, if investors are prepared to wear the cost and practical trouble of hedging their investments. At the same time, US 10-year yields are now higher, providing more room to play with.
“As a portfolio manager, I’m always looking for asymmetries,” says Riddell. “Situations where there’s not too much downside if we turn out to be wrong, and a lot of upside if we’re right. The US right now looks the opposite of that. Any news could cause a volatility spike. And there are clear risk events around the corner.”
Vote emerging?
If the dollar is going down, and US rates eventually with it, then markets seem agreed on one thing: one of the beneficiaries will be emerging markets, battered in a decade that saw developed world investors favouring the US stock market over all else.
“We had a very bad 10 years in emerging markets with a lot of stories, lots of default,” says senior sovereign debt analyst Andressa Tezine. “Finally, we are emerging here towards a better period. We have better growth, better interest rate differentials and some currency appreciation. There’s a lot of positivity.”
The big risk to that story would be higher inflation in the United States that forced the Federal Reserve to raise US rates higher and drew capital back.
“The common factor that affects all of them is the dollar again,” says Riddell. “In an environment where the dollar is very overvalued and the dollar weakens, that is almost always a good thing for emerging markets. [But] if the Fed unexpectedly has to hike when actually there are quite a few cuts now priced in, that would probably push the dollar up. That's probably the biggest risk.”
No correlation in cash
Foster, however, who has been investing in Treasuries for years, is sceptical about the market view of the path of inflation in the US and believes the way may be clear for cuts in headline rates.
“Markets are pricing in a fairly sharp pick-up in inflation in the near term, and then also a very sharp rebound. I expect the impact to be more drawn out,” he says.
“If inflation does turn out to be fairly contained and fairly spread out, then that gives the green light for rate cuts.”
If that proves not to be the case, the overall higher-yield environment makes holding cash a far more attractive idea than in the past.
“If you're a little bit concerned about the correlations of equities with longer dated government debt, then with cash you have zero correlation by default,” says Foster. “And actually, you prefer it if yields go up because you earn more and you have a 4.5 per cent dollar yield. That looks pretty good to me compared to the alternatives.”
