In brief

• It has been a particularly challenging year for multi-asset investors with both global equities and bonds down ~24.4% and 12.6% respectively.
• Given the uncertain macroeconomic outlook and our view that volatility could persist, staying invested through an income approach that is more heavily weighted towards high quality core bonds while right sizing U.S. HY is a sound strategy in today’s environment.

Cash has outperformed this year, but should underperform in the long run

It has been a particularly challenging year for multi-asset investors with both global equities and bonds down ~24.4% and 12.1% respectively. Typically, we would have expected bonds to bolster the downside volatility in equities but this year global bonds did not live up to expectations. With inflation in the developed world ex-Japan at multi-decade highs, central banks were forced to pivot hawkishly to restore price stability to their respective economies. What followed was one of the most aggressive sell-offs in global bonds in the last couple of decades. While commodities continue to be the best performing asset class year-to-date (YTD) on the back of supply side issues, U.S. nominal cash have also caught investors’ attention. Certainly, its 0.6% performance YTD looks more attractive on a relative basis when compared to equities and bonds are down double digits. However, once we back out the currently high levels of inflation from nominal cash returns, investors still end up with a negative real return.

In fact, the proof is in the numbers when it comes to nominal cash being the worst long-term hedge against inflation when compared to core bonds, riskier credit and equities. An investor who invested $100 over the past 30 years in U.S. equities would have seen that grow to $818 as of the end of August this year in real terms. For U.S. high yield and U.S. core bonds, $100 would have grown to $391 and $195 respectively. Depending on individual risk preferences, even taking low risk in the form of high-quality core bonds would have more than preserved one’s purchasing power. What’s astounding is even though cash rates in the 90s and early to mid 2000s were much higher, if that same investor had stayed in cash the whole time, $100 of initial investment would have fallen to $95 in real terms. Nominal cash is indeed not as safe as people think it is.

In trying times where macroeconomic uncertainty continues to be high, we are strong advocates for leveraging income investing to navigate heightened recessionary risks. Most importantly, this approach helps investors to get paid to wait as we continue to closely assess the situation. 

  Exhibit 1: Annualized Monthly Returns Across Income Producing Assets

Source: Bloomberg, National Bureau of Economic Research (NBER), J.P. Morgan Asset Management. Annualized monthly returns during time period: 10/31/2000 - 08/31/2022.

Income sources to consider

1. U.S. Investment Grade (IG)

• As Exhibit 1 shows, U.S. IG has historically delivered positive returns during difficult times as high-quality companies with good balance sheets continue to be able to make good on their interest payments.
• We think short to intermediate duration exposure looks the most interesting now. A 3Y U.S. IG bond yields 5.4% today. Extending the maturity profile to a 30Y U.S. IG bond only provides ~40bps of additional compensation in yield. We think there are still risks to core inflation being stickier than expected and would recommend shorter duration exposures to minimize losses, should rates move higher.
• With cash yields at ~3%, we often get pushback from investors. Why would I take on additional risk in U.S. IG for a percent or two more if I could earn 3-4% with certainty? It’s a valid point but 3-4% with certainty still loses to inflation. What people don’t realize about the quoted yield in U.S. IG is that this is only an indicative number that an investor should earn when all the bonds mature at par value. It does not consider the potential capital appreciation that an investor can benefit from if rates were to peak and start falling once economic growth and inflation deteriorates to a point where the Federal Reserve (the Fed) can deliver a dovish pivot. We do think that is a very plausible outcome given the headwinds that the U.S. economy is facing.

2. U.S. Securitized (Agency Mortgage-Backed Securities (MBS))

• Unlike credit, the main risk when investing in Agency MBS is prepayment risk. With the 30-year mortgage rates in the U.S. more than doubling from ~3.3% to 6.9% YTD, it is unlikely that we will see homeowners rushing to prepay their mortgage or refinance into a new mortgage. With much improved fundamentals in the housing market compared to pre-Global Financial Crisis and with peak pain from negative convexity behind us, the certainty of cashflow and differentiated risk profile looks interesting.
• Selectivity remains key against a backdrop where the Fed continues Quantitative Tightening (QT) with higher-coupon mortgages appearing to be more attractive in today’s environment.

3. U.S. High Yield (HY)

• While U.S. HY tends not to deliver positive returns during a recession, we think a ~9.7% yield handle is appealing to long term investors that are not too sensitive to price fluctuations. Strong fundamentals combined with the reality that even if we do get a recession, it should be a short and shallow one leads to our view that right sizing U.S. HY in one’s income portfolio can be quite beneficial. Historically, investing in U.S. HY at a 9-10% yield handle have coincided with an average next twelve months return of 9.4%.

Investment implications

Given the uncertain macroeconomic outlook and our view that volatility should persist, we think staying invested through an income approach that is more heavily weighted towards high quality core bonds (IG and Agency MBS) while right sizing U.S. HY in the portfolio as a yield enhancer over the longer term is a sound strategy in today’s environment.

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