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Bond blip raises new questions for allocators; Buyers weigh up runaway small-cap exposure

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Silver linings

With bond yields on the rise and equities seemingly taking a breather, allocators’ attention is turning once again to inflationary pressures and how they might affect portfolios.

There are plenty of sanguine voices around, and with good reason. Thus far, this isn’t the same kind of shift as seen in 2013’s taper tantrum. The front end of the yield curve remains pretty well anchored; it’s longer-dated US Treasuries that have sold off in recent weeks. That emphasises this is a story about economic growth rather than worries about imminent rate rises – for now, at least. As the FT put it over the weekend, “it’s called a recovery”.

So while equities are down this morning, it’s not necessarily the case that bonds and shares will be falling in tandem any time soon. Of course there are also implications closer to home: other parts of the fixed income universe will also be impacted by rising Treasury yields.

For US high yield, where the average yield is now less than 4 per cent – latest developments may not prove too bad. Analysts at UBS said last week that “while rising Treasury yields could weigh on investment grade credit, a larger yield cushion makes high-yield bonds less vulnerable”.

That dynamic has played out in recent days’ price action, as IG bonds’ greater sensitivity to sovereign debt saw them struggle in relation to high yield.

As we’ve discussed before, the investment grade market is still where most wealth managers keep their credit exposures. So the implications of this move need careful consideration. If short-term rates remain anchored, fund selectors and fixed-income managers need not be overly concerned about their credit picks. It may even give them an opportunity to buy some higher quality bonds at higher yields.

Equally, this may be another reason to move further along the risk spectrum and seek out HY debt. There are risks there, too – but an improving economy shouldn’t spell disaster for this part of the market.

Growth spurt

Other parts of the US market are also giving wealth firms plenty of food for thought. Motoring US small caps have now risen almost 50 per cent since the start of November – a shift that we’ve documented more than once in recent weeks, and one that is being tapped by many DFMs within their portfolios. A strengthening pound may have shaved a little off these returns for UK-based buyers, but gains are more than enough to mask that effect.

Yet for fund buyers looking for reasons to be nervous, these rises are arguably more concerning than developments in the bond market.

As the Wall Street Journal reported last week, more than 300 companies in the Russell 2000 now have larger market caps than one or more S&P 500 constituents.  Fourteen members of the Microcap index are in the same boat.

On a forward P/E basis, the Russell 2000 is now trading at more than 50 times estimated earnings: more than twice its historical average, according to WisdomTree. The US isn’t the only market to have seen small caps take-off in recent months, but the signs of speculative excess are obvious.

In contrast to mainstream US equities, most DFMs take actively managed exposure to this part of the US market. They’d hope that their managers are taking a prudent approach to runaway shares. As a very crude measure of that prudence, it should be noted that only three US small cap funds have beaten the Russell 200 since the start of November. But more than a quarter of DFMs with US small-cap exposure are holding passive options – and they’re likely keeping an even warier eye on current gains.

Automatic stabiliser

To continue the sterling story mentioned above: the pound’s strength is another blip (of sorts) for portfolios that allocators may not mind too much. Sterling has moved above $1.40 to hit its highest level in three years – and its ascent has, as discussed, taken the shine off some overseas returns of late.

That’s a simple reversal of the process that has taken place in previous years, wherein sterling weakness helped either boost or bail out international positions. The pound’s rally, however, has coincided with a period of strength for equity markets. It arguably confirms the theory we discussed a few months back: sterling’s newfound status as a risk-on asset may lead to unwelcome comparisons with EM currencies, but it also means it acts as a natural stabiliser for wealth portfolios.

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