The diversification advantage of bonds has been restored this year, as inflation has fallen and positive real interest rates have emerged. This is a relief, according to Flavio Carpenzano, Director of Investments at Capital Group, who still describes 2022 as a “worst-case scenario.”
Carpenzano made these statements during an interview in London, where Capital Group held a media day for journalists. “Inflation seems to have normalized by 2024, which gives the U.S. Federal Reserve room to further cut interest rates. It’s a question of when, rather than if, this will happen.”
Up until 2022, bonds were seen as the “safe” part of the portfolio, outperforming equities in times of turmoil. However, the position of bonds came under scrutiny during a period of high inflation and debt burdens, after the asset class failed to deliver on its promise two years ago.
Carpenzano emphasized once again that the situation in 2022 was exceptional: “What we experienced two years ago was a phenomenon that has occurred only once before in the last fifty years. Since the 1970s, we haven’t seen such high inflation in developed markets. When inflation exceeds 4 percent, the benefits of the negative correlation between stocks and bonds begin to erode.”
Central banks were forced to raise interest rates to curb inflation, bringing an abrupt end to the low-rate policy that had supported markets in previous decades. Since 2024, inflation appears to be under control, and central banks have embarked on a path of rate cuts.
Return of diversification benefits due to lower inflation
“Now that inflation has normalized and structurally remained below 3 percent, we are seeing the return of diversification benefits. When stock prices plummeted in the summer due to the unwinding of the carry trade in Japan, bonds held up well. This once again highlights the defensive nature of bonds in the investment portfolio,” says Carpenzano. Bonds also outperformed during a stock market decline in the first week of September.
Carpenzano expects inflation to remain relatively high in the near future. Meanwhile, interest rates are currently significantly higher than in the years preceding the Covid pandemic. “We’ve moved from negative to positive interest rates, in both nominal and real terms. It is now expensive to maintain a cash position when you compare the spot rate of money market funds with bond yields.”
Capital flows support the argument that demand for bonds is returning. “Investment-grade bonds, in particular, are attractive due to the income they generate and their diversification advantage over stocks, the two main qualities bonds must fulfil.”
American exceptionalism
In the bond market, Carpenzano observes that spreads on U.S. corporate and high-yield bonds are narrower than in Europe and Asia, where spreads reflect a higher risk premium. “For spreads in the U.S. to widen, a catalyst is needed, such as a major macroeconomic shock.”
Global economic growth is primarily driven by the United States, Carpenzano highlights. “The expected soft landing of the U.S. economy has not materialized, and the labour market appears robust. With approximately 3 percent growth, the U.S. has the highest growth rate among developed markets, largely due to developments in artificial intelligence and data centres. Additionally, American companies are showing strong balance sheets, as they borrowed at extremely low rates during the pandemic and took on little new debt, keeping capital costs barely affected.”
In Europe and Asia, the outlook is less promising. Europe is becoming less competitive due to a lack of innovation and excessive regulation. Where growth from China could once be counted on, the country is now undergoing a sharp correction in its housing market and unwinding of excessive debt. Carpenzano speaks of American exceptionalism, where the world’s largest economy must carry the weight on its own.
This article was originally published on Investment Officer NL.