A key question for financial market participants is where the economy sits in the business cycle. Using a model of fifteen economic variables (employment, manufacturing, equity market levels, etc.), Goldman Sachs believes the US is still in the early stages of the economic cycle. In fact, Goldman gives us just a 5% probability of recession in the next six months. Underlying their assessment of our location in the cycle are labor market slack, subdued inflation and monetary policy consistent with “easing.” However, Goldman warns we may be crossing over into mid-cycle soon. Early- and mid-cycle are pretty similar qualitatively, they write, but we can expect employment slack to tighten even further, inflation to pick up slightly and, perhaps most importantly for fixed income investors, the interest rate curve to begin to flatten, led by the front end rising. Assuming Goldman’s assessment of both our location in the economic cycle and the probability of recession are correct, this seems like a dire prognosis for bonds, but our research suggests otherwise. Investors expose their principal to interest and credit risk when buying and holding bonds, but also accrue income daily, a concept popularly called “carry.” Our research suggests that the total return in portfolios with lower average maturity profiles are more dependent on carry than on shifts in interest rates. With the concept of carry in mind, fixed income is a powerful portfolio diversifier, and, regardless of where we are in the cycle, the risk of significant capital erosion from a well-positioned bond portfolio is minimal.
Sources: Goldman Sachs, SNWAM Research