Why might investors want to consider the global fixed income universe today?
Well, let’s take a look at the opportunity set. The Bloomberg Global Aggregate Index is a flagship benchmark for the world’s investment grade bond markets. The index is capitalization-weighted, with over $66 trillion in bonds from over 70 countries.1 In its unhedged, multi-currency form, it is also an index that many US investors have been happy to ignore.
Ignorance has been profitable until recently in our view. Domestic US bond indices, as well as US dollar-hedged global or international indices, have beaten global unhedged returns for the past five years. But as the world changes, we believe that this may not be the case for much longer. The long USD bull market may be coming to an end. In our view, a number of factors from deficits to Fed policy to geopolitics could bring the dollar bear out of hibernation. So, if the USD weakens, as we expect, future investors may wish they had included an unhedged global bond strategy in their asset allocations.
Can you say more about the USD bull market ending?
We believe big dollar movements are the result of big global portfolio changes that reflect a shift in broad investor preferences. The dollar is trendy, with distinct periods of bull markets, bear markets, and sideways markets. Such periods include the 1970–1980 USD bear market, the 1980–1985 USD bull market, the 1986–1990 USD bear market, the 1995–2000 USD bull market, and the 2001–2007 USD bear market.
More recently, we view the period beginning in 2010 as one such possible bull market. In our view, USD strength can be ascribed to (1) disappointment in the global growth recovery and a haven bid for the USD, plus (2) a second tech-centered equity boom. The S&P 500®
Index has massively outperformed most other global equity markets, and (3) the euro and yen have suffered from recessionary or deflationary local fundamentals and the lowest interest rates in recorded history. The USD rallied and then peaked in December 2016. Having undergone roughly a 9% decline since that high, however, we wonder whether the next USD bear market is already well under way. This period is illustrated below among other USD drawdowns since the 1970s.
Figure 1. USD Drawdowns Since 1970s
Sources: US Dollar Index (DXY), Bloomberg, data January 30, 1970 through March 31, 2021
What current indicators of the US and global economy support your thinking?
Our thesis is that a major shift in global investor preferences could trigger a dollar bear market – there is something big that investors want either to buy outside the US or to sell in the US. Currently, we see various possible triggers for sustained USD weakness.
Global Recovery. We believe if we reach the optimistic scenario of an ebbing pandemic, successful vaccination rollouts, and a global activity rebound, investors may be more interested to invest in growing economies around the world, rather than the safe haven of the USD, as has been the case recently.
Twin Deficits. While the US current account deficit of about 2.5% of GDP is modest, the federal budget deficit is projected at roughly 15% of GDP this year, and possibly higher with effects of a new stimulus plan. These twin deficits have been bearish for the USD in the past.
Too Many Dollars. The Federal Reserve has moved to rescue the US economy and US asset markets due to Covid-19, such that the Fed balance sheet has jumped from 19% to 36% of GDP and is still growing. Once the precautionary demand for USD ebbs in a recovery, this could be problematic.
Inflation? Rising long-end government bond yields and accelerating US growth in early 2021 have investors refocused on inflation risks. Furthermore, the Fed has officially changed policy on inflation to tolerate an overshoot of its 2.0% core consumer inflation target. Combined with our previous points, inflation could be challenging for the USD.
Equity Bull Market Pause or Reversal Complacency. Equity bull markets do not last forever. If foreign investors decide to sell or merely diversify out of US equities, the USD may weaken in our view. Regulatory changes could also be a factor.
Taiwan. Our least favorite USD bear market scenario would be a successful occupation of Taiwan by the People’s Republic of China. It would be seen as a geopolitical failure for the US, not to mention a humanitarian disaster, among other significant issues.
Who Might Rise? For the USD to fall, another currency must rise. We view potential currency outperformance in non-Japan Asia. The DXY Index would likely fall more and faster if Japan and the eurozone perk up a bit, which would require both economies to overcome their deflationary tendencies, weak growth, and low yields. We view this as an argument for the added opportunities of a global, rather than an international bond strategy.
What does the current USD downtrend mean for fixed income investors?
We see it as an investment opportunity for non-US securities: Currency could potentially be an attractive return generator compared to the low yields most investment grade fixed income opportunities currently offer.
Currency risk has been out of favor recently. For example, over the five year period ending March 31, 2021, we believe US investors didn’t miss much if they skipped the international bond market. Only in calendar year 2017 did the unhedged global market outperform US bonds. If investors did own foreign bonds, they would have outperformed via a USD-hedged global or international strategy. They would have benefited from a positive USD hedge gain, favorable exposure to rallies in the European and Japanese bond markets, and avoiding currency return volatility.
Beyond currency exposure, how else are global bond strategies attractive?
While we recognize that US domestic bond strategies have outperformed currency-active global bond strategies in recent years, we believe the next five years will likely be different and relative global outperformance may be substantial. Beyond the broad country exposure of the Bloomberg Global Aggregate Bond Index, its market breadth creates alpha generation opportunities beyond the diverse currency mix.
Active managers are presented with relatively high dispersion and capital appreciation opportunities among local markets, as well as a diverse set of attractive yields from the benchmark’s emerging market countries. For global strategies with the flexibility to invest in non-benchmark sectors, we believe global high yield corporate and sovereign investments may further enhance the opportunity set.
How is the Loomis Sayles Global Bond Strategy positioned?
Well, we currently favor being more than half invested in non-dollar currencies. We believe we are well positioned for a dollar bear market, if one should occur. It is important to note that ours is not strictly an international, but a global strategy. Rather, we holistically incorporate a US core fixed income investment with the blended opportunity seeking to extract relative value from less correlated non-US markets and alpha strategies.