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May 15, 2023 | 12 Minute Read
Head of Fixed Income Macro Strategies
Lead Portfolio Manager, Global Multi-Sector Fixed Income
Macro Strategist, Fixed Income and Liquidity Solutions
In the last cycle, a “Goldilocks” regime of neither too high nor too low growth and inflation saw central banks maintain easy policies that supported the economy and financial markets. The wave of liquidity and downtrend in interest rates helped to lift assets, with low-to-negative yields on high-quality core fixed income leading investors down the quality ladder and out the maturity spectrum in search of positive yields. Some investors rotated out of fixed income altogether into equities and other risk assets. This seemed logical when portfolios were supported by benign macro and ultra-loose financial conditions.
But the nature of cycles and financial markets is changing. Structural shifts such as decarbonization, deglobalization and geopolitical instability suggest volatility—once episodic—has turned endemic. Furthermore, although investors often see bear markets and recessions as binary events, in reality, they come in different shapes and sizes. In the post-pandemic era, we expect changes in the economy to create more triggers for volatility and bearish sentiment, even if those episodes do not result in an outright bear market or recession. For example, physical climate risks and geopolitical tensions may cause supply disruptions in geographically concentrated “old economy” commodities that are critical for “new economy” clean technologies. Lithium, which is crucial to battery performance, is a prime example; over 50% of the mineral is concentrated in areas with high water stress levels and the world’s top three producing nations—including China—control well over three-quarters of global output.1 High levels of concentration and complex supply chains increase the growth risks that could arise from future supply disruptions.
Banking sector stress in March 2023 demonstrated that negative risk sentiment can shift rapidly under tighter financial conditions and in an era of social media and digital transactions. We believe restoring allocations to core fixed income can help to balance portfolios through growth-driven bearish episodes. Indeed, this is what we saw in March when high-quality bonds generated positive returns, partially offsetting weakness experienced elsewhere.
Source: Goldman Sachs Asset Management. For illustrative purposes only.
Core fixed income assets such as high-quality government bonds have historically balanced multi-asset or multi-sector fixed income portfolios due to their lower volatility relative to cyclical assets. For risk assets including equities, there is significant upside for gains, but also greater potential for downside due to company or sector-specific developments as well as economic conditions. By contrast, upside potential for high-quality bonds is largely capped at coupon and principal payments, with downside performance largely driven by interest rate movements as opposed to credit risks which are higher for riskier parts of fixed income like high yield (HY) and emerging market debt (EMD).
Further, core bonds have tended to have a low or negative correlation with equities and other risk assets which drives potential diversification benefits. For example, US 10-year Treasuries have a negative beta to growth and positive beta to equity market volatility. In other words, when growth is weak or equity volatility picks up, US 10-year Treasuries tend to perform well, while risk assets weaken.
Source: Goldman Sachs Asset Management, Macrobond, Bloomberg. As of April 18, 2023. Based on data since 1995 except for US IG credit which is since 2000 and EMD which is since 2005. Growth is measured as the 3-month change in the Global PMI index. Volatility is measured as the 3-month change in the VIX index.
Both portfolio properties of core bonds—lower volatility and negative correlations—were disrupted in 2022 when aggressive monetary tightening to tame elevated inflation caused bond market volatility to surge. The sharp rise in bond yields generated declines across almost all financial assets, especially long-duration ones. Consequently, asset class diversification offered little benefit.
The experience of 2022 has understandably led to some despair over the value of balanced portfolios and role of core fixed income. In our view, however, 2022 was a rare occurrence that is not indicative of the long-run potential of balanced portfolios or bonds. Instead, we think the protective power of core bonds has strengthened. Owing to a significant rise since the start of 2022, higher yields are now creating more room for core bonds to potentially buffer declines in cyclical assets during negative growth shocks. This marks a material change to the last cycle when bond yields hovered close to their effective lower bound, with limited room to fall and protect portfolios.
In addition, historical evidence suggests that a normalization of inflation tends to be accompanied by diminishing and eventually negative correlation between bonds and risk assets. We don’t expect a return to the “Great Moderation” era when the negative correlation between bonds and equities was relatively stable. Structural forces like a new form of globalization, driven by a desire for resilience and security rather than cost and efficiency, suggest that inflation as well as growth will drive volatility in the post-pandemic era. But reassuringly, long-term inflation expectations remain well anchored. This will help inflation recede from the current elevated levels as pandemic supply distortions fade and demand moderates, even if it does not return to the dormant levels seen before the pandemic. In turn, this will allow rate volatility to subside, while growth re-emerges as a driver of market volatility. Against this backdrop, we expect bonds to become less positively correlated with equities, and offer diversification benefits and protect portfolios when other assets weaken.
Source: Macrobond, Goldman Sachs Asset Management, University of Michigan. As of March 2023.
One upside of the transition to a higher rate regime is that the forward income and total return potential of core bonds has improved significantly. The steepest US Federal Reserve hiking cycle since the 1980s has lifted US Treasury yields well beyond lower bounds, with the 1-year yield rising from 0.4% at the start of 2022 to 4.6% at the end of 1Q 2023.2 As a result, the gap with the earnings yield of the S&P 500 Index has narrowed. Put simply, with high-quality bonds once again generating attractive income, we believe the age of "There Is No Alternative" (TINA) to equities or other risk assets has ended. But simplistic assertions are ill-suited to today’s complex world. Higher interest rates, unpredictable markets and elevated economic uncertainty call for an active approach to asset allocation, security selection and portfolio construction.
Though the magnitude and timing of policy actions may have differed, the direction of travel for monetary policy has been fairly synchronized across developed market (DM) central banks since the onset of the pandemic, with rapid easing in 2020 followed by aggressive tightening since late 2021. But we expect the end to the hiking cycle to be more staggered and the next phase of policymaking to be more mixed. A key factor driving this differentiation will be the varied situation in rate-sensitive housing markets. We expect this divergent central bank policy environment to create more opportunities for active relative value interest rate and curve views.
Source: Goldman Sachs Asset Management, Goldman Sachs Global Investment Research. As of April 19, 2023. Level of concern is based on central bank comments on the housing market from policy statements, monetary policy reports, financial stability reports, press conferences, interviews, and speeches. Economic vulnerability is based on various factors including residential investment relative to GDP, household debt relative to disposable income, share of households with mortgage debt, share of floating-rate mortgages and housing as a share of overall wealth.
We believe other segments of core fixed income such as investment grade credit and agency mortgage-backed securities also offer attractive income and investment potential. For example, US investment grade credit yields more than 5%3 and carries limited cyclical and refinancing risk, with just 16% of bonds in the market scheduled to mature in 2023 and 2024.4 Furthermore, higher yields reduce duration risk, as higher income helps to offset capital depreciation should rates rise further. Broadly speaking, as episodes of growth volatility resurface, we expect cyclical assets to face heavier headwinds than core bonds. And fortunately for multi-asset investors, higher yields on high-quality bonds alleviates the need to go down the quality spectrum or out the yield curve for income at a time when we may encounter more frequent negative growth shocks.
Source: Macrobond, ICE BofAML, Goldman Sachs Asset Management. As of April 21, 2023. Past performance does not predict future returns and does not guarantee future results, which may vary.
Even as we move beyond the economic peculiarities caused by the pandemic and war in Ukraine, the investment conditions of the post-pandemic regime will likely be less favourable than the Great Moderation era that started in the 1980s. We expect less stability and predictability, and more episodic volatility, driven by both inflation and growth concerns. We believe a restored allocation to core fixed income can help to balance portfolios through these episodes given higher yields have significantly strengthened the protective power benefits and income benefits of high-quality bonds.
The pandemic has also shifted policy priorities, with rising commitment to decarbonization, as well as renewed urgency to achieve energy security, particularly in Europe. Financing the energy transition will require vast amounts of capital and the global bond market will be an important source of financing. As companies from more sectors and governments in more regions issue green bonds, we expect increased opportunities for investors to replace a portion of their core fixed income holdings with green bonds.
Market stress this March served as a reminder of the value of core bonds in portfolios, reinforcing our view that 2023 will be a pivotal year for investors to improve bear (market) necessities in their portfolios by raising allocations to core fixed income, a portion of which may be green. But we believe the evolving macro and market environment requires a portfolio construction approach that is rooted in active management.
The long-term outlook for bonds depends on the development of the neutral rate, also known as r*. The neutral rate is the interest rate that is consistent with an economy at full employment and stable inflation. Central banks use estimates of it to judge whether policy rates are stimulating or restraining the economy, though it is not directly observable. In the long run, the neutral rate is thought to be determined by supply and demand for savings and should be high enough to attract savers and low enough to incentivize borrowers.
Estimates for the neutral rate have declined since the 1980s, reflecting structural factors such as aging demographics and weak productivity growth. But the pandemic and the war in Ukraine have accelerated changes in the economy that may generate higher growth volatility and inflation. At the same time, digitization of more activities in more sectors and the emergence of generative artificial intelligence5 has potential to lift productivity and growth substantially.
The impact of these forces on productivity, potential growth and the supply and demand of savings will play out over long-term horizons, and it will take time to determine whether they will generate a shift higher in neutral rates. Until we gain clarity on this academic phenomenon, we believe the practical approach for investors is to restore allocations to core fixed income where the protective power and income potential has strengthened significantly.
• Demographics: Aging populations and an increase in life expectancy in advanced economies have increased savings to a greater degree than savings drawdowns as people retire. At the same time, lower fertility rates slow labor force growth, and fewer workers to supply with capital reduces investment.
• Capital intensity: A decline in the price of investment goods such as machines and equipment relative to the price of other items produced in an economy is thought to have reduced investment needed to produce a given level of output.
• Income inequality: Rising income inequality is thought to have weighed on r* given savings rates are significantly higher for high income households.
• Risk aversion: Economic uncertainty can lead individuals to save more for future downturns, increasing demand for safe assets such as US Treasury bills.
• Dis-saving amid globalization: As globalization advanced, export-oriented policies of emerging economies is thought to have contributed to the creation of a ‘global savings glut’.6 Slowing growth in cross-border movement of goods, capital and labour (due to US-China trade tensions, the pandemic and geopolitical instability) suggests that this savings dynamic may moderate or even reverse.
• Productivity growth: Despite low productivity growth in recent years, there is enormous potential for it to move higher due to advances in generative AI and other technologies. Higher productivity growth is associated with new investment opportunities that increase demand for capital, driving rates higher.
• Public investment: Investments to create greener and more digital economies could contribute to a higher r*, but the magnitude and time horizon for investment spending is uncertain. For example, improved energy efficiency may require less energy investment and capacity.
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1The level of concentration is even higher for processing operations, where China’s share is 50-70%. See IEA The Role of Critical Minerals in Clean Energy Transitions: https://www.iea.org/reports/the-role-of-critical-minerals-in-clean-energy-transitions/executive-summary
2Macrobond. As of March 31, 2023.
3Macrobond. As of March 31, 2023.
4Goldman Sachs Global Investment Research 2023 Global Credit Outlook: There will be yield as of November 16, 2022.
5In comparison to its predecessor machine learning methods, sometimes referred to as narrow or analytical artificial intelligence (AI), generative AI technologies currently in focus such as ChatGPT, DALL-E and LaMDA are distinguished by three main characteristics: 1) their generalized rather than specialized use cases, 2) their ability to generate novel, human-like output rather than merely describe or interpret existing information, and 3) their approachable interfaces that both understand and respond with natural language, images, audio, and video. The first two advances are key to expanding the set of tasks that AI can perform, while the third is key for determining its adoption timeline. For example, ChatGPT surpassed 1 million users in just five days, the fastest that any company has ever reached this benchmark. See Goldman Sachs Global Investment Research Global Economics Analyst: The Potentially Large Effects of Artificial Intelligence on Economic Growth (March 26, 2023).
6See The Global Saving Glut: https://www.federalreserve.gov/boarddocs/speeches/2005/200503102/ and the U.S. Current Account Deficit and Global Imbalances: Recent Developments and Prospects: https://www.federalreserve.gov/newsevents/speech/bernanke20070911a.htm.
Bloomberg US Agg Corporate Excess Return MTD (US IG) is a broad base, market capitalization-weighted bond market index representing intermediate term investment grade bonds traded in the United States.
Bloomberg US MBS Index Excess Return MTD (Agency MBS) tracks fixed-rate agency mortgage backed pass-through securities guaranteed by Ginnie Mae (GNMA), Fannie Mae (FNMA), and Freddie Mac (FHLMC).
Bloomberg US Corporate High Yield Excess Return MTD (US HY) includes publicly issued US corporate and specified foreign debentures and secured notes.
ICE BofA BB US High Yield Index (US HY BB-rated) is a subset of the ICE BofA US High Yield Master II Index tracking the performance of US dollar denominated below investment grade rated corporate debt publicly issued in the US domestic market. This subset includes all securities with a given investment grade rating BB.
ICE BofA CCC & Lower US High Yield Index (US HY CCC-rated) is a subset of the ICE BofA US High Yield Master II Index tracking the performance of US dollar denominated below investment grade rated corporate debt publicly issued in the US domestic market. This subset includes all securities with a given investment grade rating CCC or below.
J.P. Morgan EMBI Global Diversified Credit B and BB Spread Index (HY EMD) is a uniquely weighted USD-denominated emerging markets sovereign index. It has a distinct diversification scheme which allows a more even weight distribution among the countries in the index.
J.P. Morgan EMBI Global Diversified IG Spread Index (IG EMD) is an unmanaged, market-capitalization weighted, total-return index tracking the traded market for U.S.-dollar-denominated Brady bonds, Eurobonds, traded loans, and local market debt instruments issued by sovereign and quasi-sovereign entities.
J.P. Morgan JULI 30 Yr (Excess Return) (US IG 30-year) represents the investment grade market and its components. Corporate bonds rated Baa3/BBB- or higher by Moody's and Standard & Poor's, respectively, with issue sizes of at least $300 million will qualify for inclusion in the index.
J.P. Morgan JULI 5 Yr (Excess Return) (US IG 5-year) represents the investment grade market and its components. Corporate bonds rated Baa3/BBB- or higher by Moody's and Standard & Poor's, respectively, with issue sizes of at least $300 million will qualify for inclusion in the index.
S&P 500 Index is the Standard & Poor’s 500 Composite Stock Prices Index of 500 stocks, an unmanaged index of common stock prices.
US 10-year Treasury is a debt obligation issued by the United States government with a maturity of 10 years upon initial issuance.
All investing involves risk, including loss of principal.
Emerging markets investments may be less liquid and are subject to greater risk than developed market investments as a result of, but not limited to, the following: inadequate regulations, volatile securities markets, adverse exchange rates, and social, political, military, regulatory, economic or environmental developments, or natural disasters.
Investments in fixed income securities are subject to the risks associated with debt securities generally, including credit, liquidity, interest rate, prepayment and extension risk. Bond prices fluctuate inversely to changes in interest rates. Therefore, a general rise in interest rates can result in the decline in the bond’s price. The value of securities with variable and floating interest rates are generally less sensitive to interest rate changes than securities with fixed interest rates. Variable and floating rate securities may decline in value if interest rates do not move as expected. Conversely, variable and floating rate securities will not generally rise in value if market interest rates decline. Credit risk is the risk that an issuer will default on payments of interest and principal. Credit risk is higher when investing in high yield bonds, also known as junk bonds. Prepayment risk is the risk that the issuer of a security may pay off principal more quickly than originally anticipated. Extension risk is the risk that the issuer of a security may pay off principal more slowly than originally anticipated. All fixed income investments may be worth less than their original cost upon redemption or maturity. High-yield, lower-rated securities involve greater price volatility and present greater credit risks than higher-rated fixed income securities.
Environmental, Social and Governance (“ESG”) strategies may take risks or eliminate exposures found in other strategies or broad market benchmarks that may cause performance to diverge from the performance of these other strategies or market benchmarks. ESG strategies will be subject to the risks associated with their underlying investments’ asset classes. Further, the demand within certain markets or sectors that an ESG strategy targets may not develop as forecasted or may develop more slowly than anticipated.
The above are not an exhaustive list of potential risks. There may be additional risks that are not currently foreseen or considered.
Diversification does not protect an investor from market risk and does not ensure a profit.
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Date of First Use: May 15, 2023. 316995-OTU-1794404