From rescuer to foe: how central banks threaten next year's market performance

Treasury inflation-protected securities are also suggesting that inflation is on the rise and that a part of the market may be preparing for it. TIPS have been outperforming Treasuries for a couple of years now, and while US Treasuries have hit a record low yield at 0.50% this year, 10-year TIPS yields have fallen into negative territory at the beginning of the year to hit -1% recently. TIPS constitute only 11% of the Treasury market, meaning that they are undersupplied. Thus, in the case of inflation, underpinning demand will continue to support high valuations.

Although the Fed is committed to holding interest rates low for longer, a democratic president will enter the White House in a few weeks, and he will look to inject liquidity to support the US economy as the Covid-19 vaccine gets rolled out. With the current monetary stimulus in place, an increase in money supply will increase the chances of inflation to rise, probably leading to monetary policy tightening.

In this scenario, the bullish market sentiment spurred by dovish central banks policies can quickly vanish provoking unprecedented volatility across all assets.

2. Interest rates and dollar shock

The direct consequences of higher inflation and monetary policy tightening are higher interest rates and a lower US dollar.

It is important to note that while Treasuries have been offering lower and lower yields, the US yield curve has been steepening. A steepening of the yield curve can occur when longer yields rise faster than short-term yields (bear-steepener) and when short-term yields fall faster than long yields (bull-steepener). The latter has happened this year: the Fed has been cutting the federal fund target rate provoking a fast dive in short-term yields and provoking the US yield curve to steepen. The market has benefited from this trend because as the front part of the yield curve was falling, the longer leg, although slower, was following suit.

Things will be different next year. We will continue to see the US yield curve steepening. However, this time around, yields will gradually rise for the previous point's very reasons.

Higher rates and a dollar shock will inflict pain to Treasuries and US corporate bonds. Longer maturities will be most vulnerable.

However, outside the US, emerging markets will gain out of a weaker dollar. That's why in such a scenario, emerging market bonds with short to mid-maturities with a buy-to-hold perspective can prove to be a good ally amid rising interest rates.

3. Zombie economy finally see a spike in corporate defaults

The massive injection of liquidity that the economy has been subjected to this year has prevented many bankruptcies. Yet, businesses were led to take on more and more debt surpassing levels that we haven't seen in almost 20 years (refer to below chart). As things go back to normality following the deployment of the Covid-19 vaccine, we can expect the economy to recover and less money to be printed. That's the time when zombie companies are going to find the toughest environment for survival, as the economy will most likely need a longer period of structural adjustment before returning to pre-crisis activity.

Therefore, it is vital to cherry-pick risk, especially when looking at lower-rated credits.

How can I protect my investments?

• Diversification. Don't put all your eggs in one basket. This means that you might still keep your favourite stocks and bonds, but they shouldn't be your only investments. You can promptly achieve diversification by buying ETFs. Exchange-Traded Funds are an excellent tool to gain exposure to various instruments, sectors and investment objectives. For example, in case you see opportunities in emerging markets corporates, but you are not comfortable in picking one particular company you can have a look at the iShares J.P. Morgan EM Corporate Bond ETF (CEMB) which give you exposure to US dollar-denominated corporate bonds issued in the emerging markets. ETFs can provide you also the opportunity to invest in local currency debt such as the SPDR Bloomberg Barclays Emerging Market Local Bond -ETF (EMDE).
  
  
• Get protection against inflation. TIPS are a great tool when it comes to hedge against inflation. However, if you don't feel comfortable trading them, you can find many ETFs that can help you to achieve this goal. The Vanguard Short-Term Inflation-Protected Securities (VTIP), Schwab US TIPS ETF (SCHP) and PIMCO 15+ Year US TIPS (LTPZ) are some of the instruments you can find and trade on the Saxo Platform.
  
  
• Consider stagger maturities. A ladder strategy is used when one seeks to invest in bonds with different maturities. As the first one matures, you will be able to reinvest in higher-yielding notes.