How we navigate between bonds and equities late in the economic cycle

Aly Somani, CFA, CPA, CA, Portfolio Manager, SLGI Asset Management Inc.

Bonds are currently offering unusually high yields, including net of market inflation expectations and relative to equities (see chart below). In the portfolios we manage, we maintain an approximately neutral position in bonds relative to equities at this time. But, we expect our next large asset-mix decision may be to overweight bonds. Presently, we think major developed economies are late in the economic cycle but not yet tipping into contraction. Historically, equities still often outperform bonds during periods like this albeit with rising downside risk. There are also near-term concerns preventing us from significantly increasing our bond allocation just yet including:

1. Bonds inconsistently functioning as a risk-reducer relative to cash

Owing to their unusual downside volatility as central banks struggle to fight inflation, as well as their absence of negative correlation to equities in recent quarters, bonds have become increasingly unreliable as risk-reducers. We expect at least a modest negative correlation of bonds versus equities to gradually return and become more pronounced when there is more evidence globally of disinflation and/or economic growth deterioration. In addition, should bonds eventually rebound as global economies weaken, we would expect investor appetite for bonds to return and accordingly limit their downside volatility.

2. Cash offering attractive income relative to bonds

Presently, most major developed economies have inverted bond yield curves as central banks attempt to slow economic growth. This results in money market securities (and potentially other forms of cash such as higher yielding savings accounts) offering a yield comparable to or in excess of high-quality bonds. Yield curves typically start to invert late in an economic cycle and do not stay inverted for more than 12-18 months before a recession takes hold (although it is taking longer than that this cycle). While bonds are not providing a high yield relative to cash presently, they have meaningful capital appreciation potential, particularly when cash yields eventually turn lower as part of an interest rate cutting cycle. Investors sitting on cash, on the other hand, will face reinvestment risk when such a cycle begins.

3. Resilient U.S. economic growth even as economies stumble elsewhere

Even as many countries including Canada witness sluggish economic growth, the U.S. economy has been resilient. There are many factors behind this. A key one stems from a federal budget deficit that is over 6% of GDP, an amount rarely seen since World War II outside of an economic crisis. The International Monetary Fund recently warned that the U.S. fiscal deficit is so large that it’s stoking inflation. We are paying increasing attention to this risk as CoreLogic, a global property information provider, just reported U.S. single-family rents increased at the fastest pace in nearly a year in February. For us, this increases the odds that shelter inflation (and inflation overall) may not decline to the extent needed for the U.S. Federal Reserve to significantly cut interest rates this year.

Overall, while we see compelling value in bonds relative to equities looking through to the start of the next economic cycle, they also face near-term challenges relative to equities. In particular, for bonds to play their traditional role as stabilizers within a balanced portfolio, a negative correlation between bonds and equities is necessary. We think that this will return in the not-too-distant future. In the meantime, we will continue to monitor economic, policy, sentiment and other factors that would impact our tactical decision-making and adapt our portfolio positioning accordingly.

Views expressed regarding a particular company, security, industry or market sector should not be considered an indication of trading intent of any investment funds managed by SLGI Asset Management Inc. These views are subject to change at any time and are not to be considered as investment advice nor should they be considered a recommendation to buy or sell. Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. Mutual funds are not guaranteed, their values change frequently, and past performance may not be repeated.

This commentary may contain forward-looking statements about the economy and markets, their future performance, strategies or prospects or events and are subject to uncertainties that could cause actual results to differ materially from those expressed or implied in such statements. Forward-looking statements are not guarantees of future performance and are speculative in nature and cannot be relied upon.

SLGI Asset Management Inc. is the investment manager of the Sun Life family of mutual funds. Sun Life Global Investments is a trade name of SLGI Asset Management Inc., Sun Life Assurance Company of Canada, and Sun Life Financial Trust Inc., all of which are members of the Sun Life group of companies.

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