Why asset class competition is around the corner

Genuine competition between asset classes could be 18 months down the line but, in the meantime, investors should look at short-term bonds and manage duration risk in a rate-rising environment.

Derek Massey, CFA, head of portfolio management, private investment management at HSBC Global Asset Management (Canada), outlined his views on the market after a strong jobs report and the Bank of Canada’s decision to stay pat on interest rates.

Massey expects another pullback and expects rate increases, which he believes will be gradual. For the next 12 months his “big house” position is slightly overweight equities, slightly underweight fixed income, while recommending a cash buffer with an eye on an increase in volatility.

He said: “I think we have to get used to the fact markets can’t go up in a straight line for ever. I think we are going to see come competing asset classes too.

“As we see rates creep higher, then capital investors are thinking: well, I didn’t want to buy a bond before because the interest rates were so low; I made my return in fixed income from capital appreciation when rates go down, but as rates start to go higher the yield starts to look a little more attractive. And the yield on a 10-year treasury is higher than the yield you can get on the S&P 500.

“So as we go down that path of continuing higher interest rates, you’re going to get this competition between asset classes, which is very healthy and something that will cause a little volatility as people look at the valuation in some of the equities and say maybe some of that should be positioned towards fixed income.”

Massey said that by having short-term bonds now, when they start to mature, investors can flip it and start to buy higher yielding bonds as rates go up.

He said that while the jobs report was strong, the wage inflation wasn’t there, which took fear out of the market and resulted in an equities rally after the February drop. However, he believes the “Goldilocks” scenario is on its way out.

He said: “I think we’ve gone from a ‘Goldilocks’ environment last year where both equities and fixed income did fairly well to an environment now where we are going to see interest rate increases which will challenge fixed income investors a little bit.

“But it’s the pace of interest rate increases that is important and because we didn’t get that wage inflation number increasing like it did previously, it takes away the need for the Federal Reserve in the US, and the Bank of Canada as well, to continue to have successive or faster rate increases.

“Having rate increases is one thing, we’ve got to get off this low base of interest rates, but it’s the pace of rate increases that’s going to drive the performance of the equity market and if we have a slower rate of rate increases, then the equity markets should be able to handle that.”