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In recent years, low bond yields and the risk of rising rates have prompted many investors to significantly reduce the weighting of these assets in their portfolios. With the promise of nominal returns close to zero, the asset class only acted as a shock absorber in the portfolio, with the equity component alone contributing towards value creation.

When deciding on portfolio allocation, investors were therefore faced with the difficult choice of either having to accept a lower expected return on their investments or ramping up the equity weighting within their portfolio, and accepting more volatility risk as a result.

A sharp YTD rise in interest rates

The recent shift in the macroeconomic context could be a game changer. The monetary tightening initiated by the main central banks of developed countries to fight inflation has led to a sharp increase in government bond yields on both sides of the Atlantic. The yield to maturity of the US 10-year Treasury note, which started the year at 1.51%, is now above 2.75%.

In the eurozone, its German counterpart rose from -0.18% to more than 1%, and the yield on the 2-year maturity returned to positive territory for the first time since 2014. The scale and speed of this rise in rates is unprecedented in the past 40 years. The sharp correction of the bond indices and the underperformance of the most defensive portfolios – generally with the largest bond weightings – will stay in people’s minds for some time.

Inflation on the horizon

Has the storm blown over? It’s hard to say for the moment. Jerome Powell and Christine Lagarde have been particularly firm on the need to prevent inflation from drifting permanently off course, at the risk of causing a more pronounced slowdown in growth, or even a recession.

The era of ultra-accommodative monetary policy appears to be over. The 75 bp increase in the Fed’s main key rate in June (biggest increase since November 1994) and the 50 bp increase by the ECB in July (first increase since 2011 and the biggest since 2000) are evidence of this, and the central banks have embarked on major monetary tightening.

Consequently, if inflationary pressures do not ease, further rate hikes could be expected in the coming months. Nevertheless, the yield levels offered by certain segments of the bond class are already considerably more attractive than they were at the start of the year. They are certainly not enough to beat current inflation, but they offer a number of opportunities and should once again allow bonds to make some contribution towards portfolio performance.

Favouring high-quality equities

As for equities, despite a significant decline since the start of the year, valuation levels do not reveal any major opportunities for the moment. Earnings expectations still appear optimistic given the risks weighing on the economy. In an environment of tighter financial conditions and sustained inflation for some time to come, equity investors will have to favour high-quality companies with solid balance sheets, sustainable competitive advantages and some price-setting power to pass on some of the increased production costs to clients.

Article written by François Chorand – Head of Investment Advisory, Banque de Luxembourg on 26/07/2022.

For more information

François Chorand
Head of Investment Advisory
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