Bonds have failed to shield investors during the Iran war. Now, some fund managers say that may be about to change, with debt poised to reclaim its safe-haven role if inflation starts hitting growth.
World equities, which dropped in the first few weeks of the war, are back near record highs, fuelled by enthusiasm over AI and corporate earnings, while sovereign bonds have been hit hard by fears of a protracted rise in inflation, which has driven government borrowing costs to multi-year and even record highs in some cases.
That has not deterred investors from buying bonds. Lipper data shows that since the war broke out, a net US$12-billion has flowed into developed-market government bond funds, accounting for all of the inflows this year.
However, the pressure on debt markets means that since late February, safe-haven 10-year Treasuries have delivered negative returns of 1.5 per cent, which, annualized, is a negative return of 5.4 per cent.
German 10-year Bunds have returned a negative 2.4 per cent, or negative 8.7 per cent on an annualized basis, compared with returns of 9 per cent for the S&P 500 since the start of the war - or 39 per cent on an annualized basis - according to LSEG data.
The most recent survey of global fund managers from Bank of America showed investors are the most underweight in bonds since June 2022 and covering a short position in fixed income right now would qualify as a contrarian trade.
Even with this most recent wobble in AI and tech stocks, equities are expensive and, with the arrival of another set of high-flying megacaps, such as SpaceX or OpenAI, they could become even more so, while the rise in bond yields means fixed income is cheaper than it has been in years.
Stocks from Seoul, to Frankfurt and New York are around record highs and valuations higher than they have been in months or even years.
“If you look around the globe, fixed income markets look very attractive; and this is also true in jurisdictions that have historically not been overly attractive like Europe and Japan,” said Konstantin Veit, a portfolio manager at PIMCO, the world’s largest bond investor.
“It’s hard to make the case that equities look very compelling,” he added.
Meanwhile, Bund yields are around 15-year highs of 3.1 per cent, while 10-year Japanese debt, at 2.6 per cent, hasn’t yielded this much in nearly 30 years.
If the Strait of Hormuz — the major choke-point for global oil flows that has been effectively shuttered during the conflict — reopens, current bets on rate rises could unravel, which would help bonds. Similarly, if it remains closed long enough to threaten global growth, bonds could benefit.
“Inflation is already appearing in global data, with a risk of second-round effects via supply chains and input costs. Growth risks appear less fully priced though, which means that bond yields could fall back once inflation fears have peaked,” HSBC Private Bank strategists said in their mid-year outlook at the end of May.
A further escalation in the conflict, or a lengthy closure of the Strait of Hormuz, which handles around 20 per cent of the world’s daily fuel needs, could push oil well above US$100, heightening concerns about the negative economic impact of an energy shock.
“While the diversification on bonds has been disappointing so far, we do think that it will improve and materialize when it really matters,” Andrew Sheets, global head of fixed income research at Morgan Stanley, said.
“Were the price of oil to spike to our commodity team’s bear case to US$130-US$150 a barrel, we think yields would start to fall as markets will turn more concerned of the effect of all of this on growth,” he added.
Oil isn’t the only risk. If rising risks around Taiwan or renewed U.S.-China tensions led to disruption in flows of critical inputs such as rare earth materials, or semiconductors, that could go straight to the heart of corporate profitability and hurt stocks.
“If you have a geopolitical event that will impact the production of semiconductors, that’s going to impact massively financial markets,” with the tech sector on the front line, said Yoram Lustig, head of global investment solutions, EMEA at T. Rowe Price.
The rate outlook is key as well. The Federal Reserve looks more likely to lean in favour of rate hikes, which the bond market has already factored in, but the stock market may not.
“Should an aggressive Fed hiking cycle materialise, then I think that would be an environment where risk assets, including equities, would not do particularly well,” PIMCO’s Veit said, adding that this is not his firm’s base case for the U.S. rate outlook.