U.S. Federal Reserve Chairman Jerome Powell’s recent Jackson Hole speech was a succinct and powerful pronouncement to vanquishing inflation that lacked support for near-term economic growth.
His message was a warning of potential hazards ahead as the Fed continues to fight any remaining inflation threats, either forecasted or unexpected.
Today’s markets are undoubtedly volatile, as investors face uncertain central bank policy (read about ECB policy here) and evolving market consensus outlooks for economic growth. We expect monetary policy to remain restrictive across major economies, despite slowing growth and rising recession risks, as global central banks struggle to gain control of persistent inflation. With the path to smooth returns across many asset classes overgrown with obstacles, we suggest investors consider the following potential benefits of investing in shorter maturity bonds:
- Front-end yields increased to attractive levels: U.S. front-end yields have climbed over the past nine months and are near 15-year highs, which could make them potentially attractive investment solutions for investors compared to the recent past. With less interest rate and credit sensitivity, short-maturity bonds can potentially outperform longer-dated bonds when rates are rising and more credit-sensitive bonds when economic growth is waning. Moreover, given the shorter-maturity nature at the front end of the curve, combined with higher starting yields, short-term bonds and strategies have the potential to more quickly reverse losses caused by market volatility.
- Positioning defensively provides flexibility to be opportunistic: We see a strong case for multi-sector portfolios to increase exposure to cash and shorter-maturity bonds to potentially increase liquidity and stability. Positioning portfolios defensively offers investors the flexibility to tactically maneuver when opportunities across various asset classes present themselves. Higher front-end rates and a flatter yield curve mean an investor doesn’t need to take substantial interest rate risk or sacrifice liquidity to receive attractive compensation for capital over the next year.
- Short-duration portfolios may offer resiliency during heightened uncertainty: Investors should remain cautious while central banks continue to tighten. Shifting a portion of an investor’s asset allocation to a diversified fixed income portfolio with less than two years of duration can potentially provide liquidity and a relatively low risk solution amid increased market volatility if longer-dated yields rise more than expected and risk assets reprice into 2023.
While we believe it’s prudent to be cautious today, investors have opportunities to be well-compensated for their patience until the road is clear and conditions turn more favorable. The U.S. economy is at, or near, stall speed and the probability of recession appears higher over the next 12-18 months. One can actively manage around this economic uncertainty by reducing risk allocations, raising cash levels, and proactively managing liquidity in a way that is both defensive, but also optimized – an approach with the potential to realize liquidity premiums to benefit returns.
Jerome Schneider leads short-term portfolio management at PIMCO.