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    All Insights Perspectives

    Bear (Market) Necessities: The Case for Core Fixed Income

    Bear (Market) Necessities: The Case for Core Fixed Income

    May 15, 2023  |  12 Minute Read

    Simon Dangoor

    Head of Fixed Income Macro Strategies

    Simon Dangoor

    Sophia Ferguson

    Lead Portfolio Manager, Global Multi-Sector Fixed Income

    Sophia Ferguson

    Gurpreet Gill

    Macro Strategist, Fixed Income and Liquidity Solutions

    Gurpreet Gill

    Key Takeaways

    • The “Goldilocks” economic and policy regime of the last cycle helped to lift assets, leading investors into riskier parts of fixed income or other risk assets.
     
    • In the post-pandemic era, we believe structural shifts such as decarbonization, deglobalization and geopolitical instability will create more triggers for growth volatility and episodes of bearish sentiment.
     
    • 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 and income benefits of high-quality bonds.

    From Sailing Through Goldilocks to Navigating Bears

     

    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.

     

     

    Structural Shifts Point to More Frequent Episodes of Growth-Driven Bearish Sentiment

     

    Source: Goldman Sachs Asset Management. For illustrative purposes only.

     

     

    The Protective Power of Core Fixed Income

     

    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.

     

     

    Core Fixed Income Has Tended to Be More Resilient and Stable When Growth Weakens, or Equity Volatility Picks Up

     

    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.

     

     

    Longer-term Inflation Expectations Remain Well Anchored, Supporting the Case for a Moderation in Inflation Which Implies Normalizing Bond-Equity Correlation

     

    Source: Macrobond, Goldman Sachs Asset Management, University of Michigan. As of March 2023.

     

     

    The Potential Income Benefits of Core Fixed Income

     

    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.

     

     

    Varied Housing Market Situations Will Likely Drive Policy Dispersion and Create Active Cross-Market Rate Opportunities

     

    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.

     

     

    TINA Turning – The Return of Income in Core Bond Portfolios

     

    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.

     

     

    Core Strength: Restoring Fixed Income Allocations

     

    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.

     

    Staying Neutral on the Neutral Rate Debate Given High Uncertainty

     

    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.

     

    Drivers of the Neutral Rate are in Flux

     

    POTENTIAL DOWNWARD FORCES

     

    • 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.

     

     

    POTENTIAL UPWARD FORCES

     

    • 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.

    Disclosures

    Glossary

    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.

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    Bahrain: This material has not been reviewed by the Central Bank of Bahrain (CBB) and the CBB takes no responsibility for the accuracy of the statements or the information contained herein, or for the performance of the securities or related investment, nor shall the CBB have any liability to any person for damage or loss resulting from reliance on any statement or information contained herein. This material will not be issued, passed to, or made available to the public generally.

    Kuwait: This material has not been approved for distribution in the State of Kuwait by the Ministry of Commerce and Industry or the Central Bank of Kuwait or any other relevant Kuwaiti government agency. The distribution of this material is, therefore, restricted in accordance with law no. 31 of 1990 and law no. 7 of 2010, as amended. No private or public offering of securities is being made in the State of Kuwait, and no agreement relating to the sale of any securities will be concluded in the State of Kuwait. No marketing, solicitation or inducement activities are being used to offer or market securities in the State of Kuwait.

    Oman: The Capital Market Authority of the Sultanate of Oman (the "CMA") is not liable for the correctness or adequacy of information provided in this document or for identifying whether or not the services contemplated within this document are appropriate investment for a potential investor. The CMA shall also not be liable for any damage or loss resulting from reliance placed on the document.

    Qatar This document has not been, and will not be, registered with or reviewed or approved by the Qatar Financial Markets Authority, the Qatar Financial Centre Regulatory Authority or Qatar Central Bank and may not be publicly distributed. It is not for general circulation in the State of Qatar and may not be reproduced or used for any other purpose.

    Saudi Arabia: The Capital Market Authority does not make any representation as to the accuracy or completeness of this document, and expressly disclaims any liability whatsoever for any loss arising from, or incurred in reliance upon, any part of this document. If you do not understand the contents of this document you should consult an authorised financial adviser.

    The CMA does not make any representation as to the accuracy or completeness of these materials, and expressly disclaims any liability whatsoever for any loss arising from, or incurred in reliance upon, any part of these materials. If you do not understand the contents of these materials, you should consult an authorised financial adviser.

    United Arab Emirates: This document has not been approved by, or filed with the Central Bank of the United Arab Emirates or the Securities and Commodities Authority. If you do not understand the contents of this document, you should consult with a financial advisor.

     Date of First Use: May 15, 2023.  316995-OTU-1794404 

    © 2023 Goldman Sachs. All rights reserved.

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