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This is a summarised version of our latest Fixed Income Quarterly Outlook. Read the full text here.
The economic recovery is well-entrenched in many developed countries and en route in many emerging countries. Leading central banks are unwinding – or getting closer to unwinding – crisis-era support measures and financial market volatility is on the up. Put all that together and there is scope for higher term premiums in longer-dated G7 government bonds, according to the latest Fixed Income Quarterly Outlook.
In these later stages of the global economic cycle, it can be expected that investors will increasingly focus on downside risks to the growth outlook as a decade of growth and inflation-focused support from central banks begins to fade. Global growth divergences, higher political uncertainty and the uncharted territory of central bank balance sheet normalisation are beginning to take on greater weight.
Risk, and with it investor compensation for holding riskier assets, will likely feature more prominently in the spread-sensitive credit markets. From the second half of 2018 on, US and EU company revenues and earnings looks set to grow more slowly, due in part to base effects. In addition, foreign buyers have switched from US fixed-income markets to other bond markets. Thus, our focus will be on preparing for the second half by rotating into asset classes which are more defensive and less sensitive to rising yields.
In credit markets, we favour higher-quality sectors and names. Given the meaningful repricing in front-end rates and credit, we can see interesting opportunities in floating-rate and other short-duration products, including investment-grade corporate bonds, CLOs and ABS. Of course, investors should make sure they select products with adequate market liquidity since volatility can be expected to remain high.
We still see selected opportunities in government bond issues by European ‘peripherals’, although we will keep a close eye on political risk, particularly in Italy. US inflation break-evens (TIPS) should also still provide value to investors as markets are still under-pricing inflation risk. As for US Treasures, we believe the path of least resistance is for further yield curve flattening in the near term, but as the economic cycle matures, we will consider the possibility of curve steepeners.
On emerging market debt, we remain convinced that local currency debt can do well, primarily driven by EM currency appreciation. We do not expect hard currency debt to deliver the stellar returns of 2017 given the now relatively tight spreads over US Treasuries and the uncertainty over US policy.
Uncertainty arising from tensions between the US and Russia and the Syria crisis, as well as lingering concerns over whether tariff-led trade stand-offs will escalate, will likely continue to impact the asset class, but we do not expect it to derail the broader story: solid growth combined with a gradual reduction of fiscal and balance of payments imbalances should continue to support EM currencies.
Given that some EM central banks are still easing monetary policy while others are embarking on a tightening cycle, we believe that a ‘buy the index’ approach is inappropriate. We would steer away from low-yielding bond markets that remain heavily correlated with US Treasuries and see many opportunities in countries with high real rates that are likely to ease monetary policy in the future.
A slew of factors has caused market volatility to tick up. Firm US inflation has prompted expectations of a steeper path for US fed funds rate increases and a rise in long-term interest rates. Concerns over the Trump administration’s ‘America First’ trade agenda, a potentially less favourable regulation of the US technology sector and no longer synchronised global economic growth have added to the wall of worry in markets and sparked demands for additional compensation for holding risky assets.
Economic data and the monetary policy outlook have provided reasons for caution. We believe the US Federal Reserve will be increasingly challenged to extend the economic expansion, while limiting the risks of a sizeable uptick in inflation and a build-up of financial market excesses. There are indications that the Fed could allow inflation to run above 2% in the near term, while keeping policy restrictive in an environment in which company and household balance sheets are susceptible to rising rates and shocks.
As a result, asset valuations may be vulnerable and risk premiums could rise. On the one hand, we can expect a major increase in US Treasury bond issuance to fund tax cuts, spending and the Fed’s balance sheet run-off. That said, we see issuance being calibrated such that borrowing costs remain under control. Over time, however, higher Treasury supply combined with an end to asset purchases by the ECB and Bank of Japan all suggest scope for higher term premiums in longer-dated G7 sovereign debt.
In the eurozone, we think the risks of an acceleration in activity have diminished, while recent inflation data suggests that the stronger euro is starting to drag on core goods prices. In China, accelerated debt reduction and structural reform efforts support our base case scenario of slower growth in 2018. As China has been one of the main drivers of global growth, this could have meaningful implications for growth elsewhere, especially for export-driven economies. This will bear close monitoring.