Strategic Asset Allocation: Bonds vs Alternative Strategies?

The recent “Fed Pivot” from a regime of tightening monetary policy to fight off inflation since March 2022, to a dramatic 50 basis point cut in September this year on the back of falling inflation and concerns about economic softening, gives rise to the obvious question: “Is this an opportunity to switch asset allocation towards bonds?”

While we fully expect the Fed to cut short-term interest rates significantly in the latter part of the interest rate cycle, we may not see long-dated bond rates decline to the same extent as short-term interest rates. Bond markets have been expecting this pivot for some time as the Fed telegraphed its intentions to cut rates as soon as inflation peaked, and other central banks also started to ease interest rates earlier this year in anticipation of the Fed’s moves. As a result, medium- and long-term bond rates have been declining for some time, and much of the anticipated cut in the Fed’s policy rate is already priced into the market.

Notably, to benefit from declining interest rates investors require exposure to longer-duration bonds where significant capital gains can be achieved. While we shifted our asset allocation towards bonds earlier this year, we also rely on our bond fund managers to extend their duration to take advantage of these opportunities, and this strategy has worked well.

But that is behind us. Where to from here? Economic data released late last week suggests that, if anything, the Fed might have moved too soon. Despite inflation moderating, the recent information shows the US economy remaining resilient with strong job growth against a backdrop of low unemployment rates. This economic robustness and resilience suggest that inflationary pressures could persist, making the aggressive 50 basis point rate cut not only unnecessary, but potentially even damaging. We are reminded of the mid-1990s, when premature rate cuts led to overheating in parts of the economy. The bond market has certainly hinted at that in price moves that immediately followed the economic updates.

Then, we have a further concern about the level of geopolitical risk in the system with active wars in several regions. In our view, there is a real and growing risk that tensions in the Middle East escalate, in which case a full-blown regional war is on the cards. This would drive up oil prices – although we don’t see this just yet, with markets remaining quite calm. Supply-side inflation would also follow from supply-chain chokes, quickly forcing central banks to tighten policies again.

Finally, almost all first-world counties are experiencing financing problems. Most high-income countries have elevated debt and continue to run government budget deficits – often in the face of low economic growth, which translates into ever-increasing debt levels. Historically, debt-to-gross domestic product ratios of 100% or more have seen governments run into trouble. Stand-out cases in point include Italy, with debt-to-GDP at 144,4%, the US (121,4%), Portugal (116,1%), Spain (112,0%), France (111,7%), Canada (106,6%), and the UK (101,4%). In response, some governments are pushing tax rates higher to finance debt. Ironically, higher tax rates will fuel inflation and curb economic growth, which would be bad for bonds.

On balance, we believe that most of the potential capital gains from bonds that could flow from a lower interest rate environment are already priced into the market. If anything, the risks are now to the upside (i.e. Higher Bond rates). Bonds will still provide reasonable income yields under these conditions, but the potential capital gains appear limited.

Beyond financial market dynamics, there are two further issues we would like to highlight for investors considering a switch from the Cannon Alternative Strategy Fund (CASF) into bonds. First, there is a three-month liquidity constraint to put this into effect due to the illiquid nature of the underlying investments. The CASF has behaved as an excellent bond proxy for our portfolios over the years providing a stable return with very little downside risk at times when bonds have been through a significant bear market; 2022 is an excellent case in point. Second, in making any switches, investors should also keep in mind Capital Gains Tax impacts. What you gain on the roundabout, you might lose on the swings when changes are made to their portfolios. For this reason, we overarchingly prefer to let the underlying managers shift bond portfolio durations inside of their funds – which means there is no tax impact – as bonds go through the interest rate cycle.

Commentary by Rob Nichol & Adrian Saville - Cannon Capital Advisors