• Stocks and bonds provide opportunities when rates fall
  • Should investors buy both asset classes and diversify?
  • We reached out to IMC Trading’s head of Research, Jordan Miyakawa

 

At the start of 2023, all the talk was about cutting your exposure to equities. But as the year progressed, sentiment turned from being underweight stocks to overweight.

Investors have piled back into stocks in a big way, pushing the S&P 500 up almost 20% this year, while the Nasdaq has gained a whopping 35%.

The surprising reversal in sentiment has been triggered by several factors – a slowdown in inflation, a resilient jobs market, and a hard landing that never eventuated.

Similarly, the bond market also looks attractive right now, particularly as central banks are nearing the end of their monetary tightening cycle.

Lower interest rates mean higher bond prices, and one has to wonder whether this is now a good opportunity to get into this asset class.

Stockhead reached out to Jordan Miyakawa, Head of Research at global financial trading firm IMC Trading, who says that while stocks should generate the best returns in a soft-landing scenario, it’s important not to put all your eggs in one basket as we can’t rule out the risk of a recession.

He believes that given the ongoing uncertainty over the outlook for the economy and inflation, diversification is crucial to navigating the current market.

“If we get a recession or a rebound in inflation, stocks could have a fair way to fall, given the optimism already priced in,” Miyakawa told Stockhead.

“Sectors sensitive to interest rates and consumption may pose greater default risk. For example, commercial real estate, consumer discretionary, hospitality, amongst others.”

He added that while bonds have lost some of their hedging ability in this high-inflation environment, they ultimately remain important hedges for stocks.

“If inflation rebounds, both stocks and bonds will likely be hit, as we saw last year.

“However, if inflation continues to ease, bonds should generate positive returns which can be a particularly valuable hedge for stocks if the economy enters a recession.”

 

Does 60/40 strategy still work?

Although a recession in Australia is a possibility given evidence of activity slowing, Miyakawa says it’s unlikely another GFC-like event will occur.

The US economy remains strong and inflation is on the right track, which means central banks may be nearing the end of their tightening cycles.

“I don’t see a recession in the near term. Data isn’t supporting that just yet, particularly in the US, and inflation is on the right track.

“However, the probability of recession will rise materially if we get a rebound in inflation that forces central banks to reaccelerate tightening,” he warned.

In that scenario, Miyakawa believes the traditional 60/40 portfolio may not provide the best diversification strategy to protect your portfolio.

“We can’t rule out the possibility of a rebound in inflation like we saw in the ’70s. Until we can be sure inflation is put to bed, I think the 60/40 portfolio is under-diversified.”

According to Miyakawa, adding allocations of cash and commodities as inflation hedges makes sense. Cash provides safety and optionality, whilst commodities have historically performed strongly when inflation rises.

“So I would retain a larger-than-average allocation to cash for safety and optionality if we do get a recession or rebound in inflation. Meanwhile, adding some commodities can hedge against a rebound in inflation,” Miyakawa said.

 

Which bonds are attractive?

Assuming one has a long enough investment horizon to withstand another bond selloff in the event that inflation rebounds, Miyakawa said he would instead be going after a number of medium and long-term bonds with attractive yields.

“Certain investment-grade corporate bonds are offering mid-to-high single-digit yields, and should fare better if there is an economic downturn.

“Short-term bonds are also attractive at these levels,” he added.

Miyakawa believes there’s currently better payoff asymmetry in bonds, and buying and holding them can offer stable, solid returns with better protection than stocks against a hard-landing of the economy.

“Holding to maturity will protect you from locking in a drop in bond price if inflation rebounds. But it’s important to do your due diligence on corporate bonds to minimise default risk.”

Now read:  The 60:40 portfolio is not dead, it just needs fine tuning… and why bonds will still play a big role

 

 

IMC Trading is a leading global market maker with more than three decades of experience, and with offices in Europe, the US, and Asia-Pacific.

The company employs state-of-the-art algorithms, statistical techniques, and innovative low latency technologies to execute its strategies.

The views, information, or opinions expressed in the interview in this article are solely those of the interviewee and do not represent the views of Stockhead.

Stockhead has not provided, endorsed or otherwise assumed responsibility for any financial product advice contained in this article. 

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