POSITION PAPER RIDING THE CYCLES. Understanding business, financial and monetary cycles in order to allocate fixed income

Transcription

1 POSITION PAPER RIDING THE CYCLES Understanding business, financial and monetary cycles in order to allocate fixed income

2 TABLE OF CONTENTS EXECUTIVE SUMMARY 2 CYCLES ARE KEY TO BOND TOTAL RETURNS 3 THREE CRITICAL CYCLES 3 CYCLES AND FIXED INCOME PERFORMANCE 6 CREATING A CYCLE-PROOF PORTFOLIO 7 ABOUT CANDRIAM 8 EXECUTIVE SUMMARY Candriam s latest research indicates that a cycle-responsive total return approach could be the solution to delivering ongoing excess returns from fixed income especially at a time when traditional benchmark-constrained bond strategies are struggling to deliver the real returns that investors require to achieve their goals. Although the portfolio asset allocation decision requires further extensive input both qualitative and quantitative, bottom-up as well as top-down the idea that investors investors can benefit from taking a cycle-aware rather than a benchmark-aware approach to fixed income now looks compelling. June 214 2

3 CYCLES ARE KEY TO BOND TOTAL RETURNS If you thought fixed income assets were all the same, think again. New research by Candriam shows just how diverse such assets can be in their response to changing economic cycles. And, by understanding different cyclical indicators, investors could be better positioned to allocate a bond portfolio to achieve excess returns on an on-going basis, throughout different cycles. To hold fixed income or not to hold fixed income? That s always been a key question for investors. And the received wisdom has always been pretty straightforward: when the economy is booming, that s the time to go underweight fixed income assets; when contraction is looming, that s the time to hike bond exposure up a notch. But is the portfolio allocation equation that simple? New research conducted by the fixed income team at Candriam Investors Group suggests that the bond decision could benefit a lot from being more sophisticated. The real allocation decision then becomes not so much whether or not to hold fixed income, but which type of fixed income to hold at which stage of the economic cycle. By analysing US economic and financial data over the past three decades, a new Candriam Fixed Income paper highlights just how diverse the returns from fixed income assets have been in response to different stages of economic contraction and expansion. But more than this, it concluded that the economic and financial indicators that are used to help determine fixed income allocation also need to be more granular to be of real value to investors. THREE CRITICAL CYCLES It is well accepted that economic contraction and expansion are key drivers of fixed income returns. But Candriam delved deeper, looking to explore the hypothesis that there are three different but interrelated economic cycles that affect fixed income performance namely, the business cycle, the monetary policy cycle and the financial cycle. The business cycle describes deviations from the long-term economic growth trend as phases of economic expansion and contraction. The Candriam team identified this cycle by aggregating five leading indicators into the Candriam Composite Business Cycle indicator: non-farm payrolls, industrial production, consumer confidence, capacity utilisation and real personal income. EXHIBIT 1: US Business Cycle & Candriam leading indicator 2% 1 PEAK 15% 1% 5% % -5% -1% -15% -2% TROUGH -25% Candriam Composite Business Cycle Indicator US Business Cycle Difference between Peak and Troughs in Months: Average 6M Max 15M Min M June 214 3

4 The monetary policy cycle reflects the decisions taken by central authorities to raise and cut interest rates to control the money supply. Monetary policy tightens and eases in clear phases. EXHIBIT 2: US Monetary Policy Cycle This can best be seen both in terms of length and of amplitude not by plotting the absolute level of interest rates but by following the number of actions by the central bank over time and expressing these as the net cumulative number of cuts/ hikes over a rolling 12-month period Fed Funds Rate Net cumulative monetary action -5-1 The financial cycle relates the importance of the role of credit and asset prices to macro-economics. A proprietary composite financial indicator was created based on the levels of, and changes in, corporate and household credit, as well as the growth in house prices. The resulting Financial Cycle Indicator proxies simultaneously the de- and re-leveraging processes and movements in non-financial asset prices. EXHIBIT 3: US Financial Cycle AVERAGE EVOLUTION OVER THE US FINANCIAL CYCLE CONTRACTION PHASE EXPANSION PHASE Quarters into cycle Case-Shiller house prices index Real Credit Growth YoY Actual While the influence of the business and monetary policy cycles are well documented, the impact of the financial cycle levels of borrowing in the economy has been far less appreciated. Indeed, it may be argued that it took the 28 global credit crisis for economists and central banks to truly wake up to its significance. June 214 4

5 EXHIBIT 4: The three cycles YOY CHANGE 2% 15% 1% 5% % -5% -1% -15% 12M ROLLING NUMBER OF CHANGES IN THE FED FUNDS RATE % US Business Cycle US Financial Cycle US Monetary Cycle (R.H.S.) -12 Understanding the dynamics of the three cycles is key. Exhibit 4 clearly shows that the financial cycle is less volatile but longer in duration than the business cycle. Further econometric analysis also points towards clear relationships between the three cycles. The business cycle (economic growth) reacts negatively to repeated monetary policy tightening. Financial cycles tend to follow the business cycle with a degree of lag. In the past, monetary policy has not reacted strongly to changes in the financial cycle. Going forward, with the lessons learned from the 28 crisis, central banks may however pay more attention to credit markets. A higher interdependence between the financial and monetary cycles in the future could therefore be anticipated. In the current environment, the US financial cycle is already well advanced with credit and house price indicators well above their long-term trend, while the recovery in the business cycle appears to have stalled. These interdependencies provide a valuable strategic tool. By following carefully selected leading indicators in each cycle and knowing their trending behaviour, it becomes easier to correctly identify the current stage and imminent turning points in all three cycles. June 214 5

6 CYCLES AND FIXED INCOME PERFORMANCE So, what s the significance of this for fixed income investors? Fixed income is often viewed as a homogeneous asset class. But an analysis of historic returns over the past three decades reveals the diversity of performance across different fixed income assets. Crucially, it shows the differing response of fixed income assets to the easing/expansion and tightening/contraction phases of the three cycles described above. To illustrate, exhibits 5 and 6 show the response of a range of fixed income asset returns to phases of contraction and expansion in the business cycle (exhibit 5) and the financial cycle (exhibit 6). A high positive regression coefficient indicates a pro-cyclical response (i.e returns improve as the cycle expands and decline as it contracts). A negative co-efficient indicates asset performance that tends to be counter-cyclical (i.e. returns deteriorate as the cycle expands and improve as it contracts). EXHIBITS 5 & 6: Fixed income responses to the Business and Financial Cycles BUSINESS CYCLE AND ASSET RETURNS: REGRESSION COEFFICIENTS UST 1Y UST 2Y Infl. Linked Inv. Grade High Yield Convertible BC Contraction x Composite BC Indicator BC Expansion x Composite BC Indicator FINANCIAL CYCLE AND ASSET RETURNS: REGRESSION COEFFICIENTS UST 1Y UST 2Y Infl. Linked Inv. Grade High Yield Convertible FC Contraction x Composite FC Indicator FC Expansion x Composite FC Indicator There are plenty of conclusions to draw from this data, but notable observations are: Fixed-rate government bonds perform counter to the business cycle, as their returns rise in times of recession and fall in times of business expansion. While inflation-linked and investment-grade bonds exhibit clear traits of pro-cyclical behaviour it is the riskiest bonds such as high yield and convertibles that are the most pro-cyclical and that record the strongest outperformance/underperformance during an expansion/contraction of the business cycle. Overall, higher-risk bonds such as high yield tend to underperform during releveraging phases in the financial cycle but outperform during deleveraging phases. June 214 6

7 CREATING A CYCLE-PROOF PORTFOLIO Once we appreciate just how diverse fixed income securities are in their response to cycle expansion/contraction, the value of an unconstrained flexible fixed income allocation that can move between asset classes in response to different cyclical phases becomes apparent. To demonstrate the benefits of a cycle-driven approach to portfolio allocation, Candriam composed an unconstrained back-tested portfolio that could invest in four US fixed income asset classes (US Treasuries, investment-grade, high-yield and convertibles) in any combination. The allocation of this fully flexible portfolio was actively shifted amongst assets in line with the research findings about the responses of different fixed income assets to stages in the business and financial cycles. Candriam also devised a semi-flexible portfolio that always maintains a 5% allocation in US Treasuries regardless of the cycle stage and, as a control, a portfolio 1% invested in US Treasuries. Exhibit 7 shows that both the semi-flexible and the fully flexible, unconstrained portfolios provide excess returns over a longterm horizon, with the unconstrained portfolio recording significant outperformance since the global credit crisis. What s more both the unconstrained and the semi-flexible portfolio underperformed the pure US Treasuries portfolio less than 1% of the time. Conclusion These results illustrate that a benchmark-constrained approach can not effectively perform in all the various cycles. In this respect, backed by a 1-year track record, Candriam offers a real alternative to investors through its unconstrained total return strategy. Within this strategy, flexibility and diversification are the two requisite key investment pillars. EXHIBIT 7: Unconstrained allocation delivering long-term excess return Flexible Bond Portfolio Semi Flexible Bond Portfolio (5% US govies) US Sovereign bond index Sources: Candriam, JP Morgan The flexibility relies on management constraints not linked to any benchmark, such as dynamic duration allocation ranging from -2 to 1 years or an exposure to currencies other than the euro to a maximum of 3%. The diversification is provided by a multi-asset class approach (from AAA bonds to high yield and convertible bonds) and a global geographical coverage (from developed to emerging markets). By adopting such a flexible, dynamic approach to asset allocation within a diversified fixed income portfolio, Candriam s unconstrained bonds approach aims to generate positive returns over a 2- to 3-year investment horizon, throughout all cycles. June 214 7

8 ABOUT CANDRIAM Candriam Investors Group has been investing in fixed income on behalf of our clients for more than 25 years. Today, we manage over EUR21 billion in fixed income assets (EUR75 billion total AUM as at end March 214). Across fixed income, our core objective is to add real long-term value while avoiding risk. Through a combination of top-down analysis, bottom-up stock selection and dynamic allocation of risk budgets, we look to maximise risk-weighted returns in every portfolio we manage. A history of bond innovation and a decade in fixed income total return Candriam has a track record of bond strategy innovation to meet a wide range of risk-return goals. We launched our first Global Bond Aggregate Fund in 1989 and our first emerging market debt fund in Our total return strategy was established in 24, giving us a decade of experience in a segment that most other fund managers only entered about five years ago. A fund management team supported by dedicated and specialised fixed income expertise Our fixed income fund managers have, on average, close to 15 years industry experience, of which more than 11 years have been spent with Candriam. They are supported by 18 experienced analysts providing dedicated insight into developed and emerging markets, plus also financial and non-financial corporate bond sectors. Investment insight and management is also optimised with the support of two specific teams: on the one hand, the Investment Engineering Team made up of 9 engineers developing proprietary credit models and relative valuation tools. And on the other hand, the trading desk with 3 dedicated fixed income traders in charge of the best execution on secondary markets. Nicolas Forest Global Head of Fixed-Income Co-Fund Manager Alain Péters Lead Fund Manager for Total Return bond strategies Gilles Lejeune Co-Fund Manager & Lead Manager for Global Bond funds By combining multi-cycle analysis with well-resourced experience, we are committed to delivering robust investment management and innovative thinking across the fixed income universe. June 214 8

9 CONTACT US: contact.candriam.com This document is provided for information purposes only, it does not constitute an offer to buy or sell financial instruments, nor does it represent an investment recommendation or confirm any kind of transaction, except where expressly agreed. Although Candriam selects carefully the data and sources within this document, errors or omissions cannot be excluded a priori. Candriam cannot be held liable for any direct or indirect losses as a result of the use of this document. The intellectual property rights of Candriam must be respected at all times, contents of this document may not be reproduced without prior written approval. Warning: Past performances of a given financial instrument or index or an investment service, or simulations of past performances, or forecasts of future performances are not reliable indicators of future performances. Gross performances may be impacted by commissions, fees and other expenses. Performances expressed in a currency other than that of the investor s country of residence are subject to exchange rate fluctuations, with a negative or positive impact on gains. If the present document refers to a specific tax treatment, such information depends on the individual situation of each investor and may change. The present document does not constitute investment research as defined by Article 24, paragraph 1 of the Commission Directive 26/73/EC. Candriam stresses that this information has not been prepared in compliance with the legal provisions promoting independent investment research, and that it is not subject to any restriction prohibiting the execution of transactions prior to the dissemination of investment research. Candriam consistently recommends investors to consult via our website the key information document, prospectus, and all other relevant information prior to investing in one of our funds. These documents are available either in English or in local languages for each country where the fund s marketing is approved. More information: