Looking to 2021, equity and bond market dynamics are fascinating to say the least. Equity markets might have one of the best backdrops in years. However, a lot hinges on the two Georgia Senate runoff elections to occur on January 5th, 2021. If the Republicans hold the majority in the Senate after the runoffs, no party would have full control and passing any extreme fiscal policy would be difficult. The likelihood of substantial increases to the corporate and capital gains tax rates would be reduced. On the monetary policy front, global central banks have proclaimed they will do whatever it takes to backstop any liquidity crisis and even any default crisis in some areas. The Federal Reserve has even changed their inflation target to an average of 2%, creating a scenario where they would let inflation run higher than 2% for a longer period if it does occur. When you couple a more down-the-middle political environment with an accommodative central bank, equity markets potentially could have the runway for more gains especially if the economy fully re-opens in the late winter or early spring with the help of multiple vaccines.
Duration, credit, and regional exposure are main components outlying the difficulties allocating to bonds. When you look at the fixed income landscape, yield compression specifically in countries where their central banks are purchasing bonds, have made it difficult to produce a suitable yield for many investors. The US 10-year Treasury yield has been hovering between .70% and .95% for the past couple of months. With that in mind, do you extend further out in duration to achieve yield in your portfolio or do you look at other areas of the fixed income markets, ones where central banks are not performing outright purchases? Here is an example outlining that dilemma. As of the writing of this article, the Greek 10-year bond was yielding approximately .63%. Greek sovereign debt is rated BB- by S&P. Compare that to other countries such as India and Russia. The 10-year yield on Indian sovereign debt is approximately 5.4% and on Russian sovereign debt is approximately 5.8%. According to S&P, India and Russia are rate BBB-. If you were a Greek citizen, what would you do? Produce almost zero yield for an investment in your own country or invest elsewhere and take on that countries’ respective sovereign credit risk and currency risk (assuming no currency hedging). For those looking for fixed income investments with higher yields, the central banks in the US and ECB have given investors little choice.
Duration extension is another possibility, but that also comes with a lot of risk. The further you extend out the more interest rate risk you are taking, exposing the portfolio to losses if interest rates rise. Highlighting duration risk even further, as of early December 2020, the Bloomberg Barclays Aggregate Bond Index has a duration of six years with a 12-month yield of 2.23%. The 3-year annualized rate of return for the index is approximately 5.25%. For the index to continue that return pace, interest rates will have to go lower because most of the return going forward will be capital return and not income return. All of these are examples of the challenging bond landscape that currently exists for most investors and highlights the need for skilled portfolio managers with the ability to navigate these waters.
One could call it a tale of two cities. Dependent on political clarity in January and vaccine rollout, equity markets might have one of the best environments it has witnessed in some time. The same can not be said for fixed income markets with yields so low in developed countries, investors are forced to take certain risks they may not be comfortable taking. As always, a diversified portfolio within the equity and fixed income subsectors can help mitigate risks for investors as we enter 2021. Given the complexity of the market and economic environment, as you review your 2021 investment portfolio, now maybe a good time to talk to a financial advisor for help or clarity on your options.
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