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There was – and will be – divergence

Jim Leaviss Jim Leaviss, head of fixed interest at M&G Investments and one of the Bond Vigilantes bloggers, offers his thoughts on the year just gone and the one that lies ahead, including portfolio positioning. This is an edited extract of his 2016 macro outlook, more of which may be read here

2015 was a bear market for US and UK government bonds, and European bonds made new record lows. Local currency emerging market debt also experienced a tough year: China’s economic slowdown created fears over global growth and commodity-exporting developing economies suffered as a result.

  • Most investment-grade corporate bond spreads in the UK and Europe were stable, although some event risk has come back in the market
  • US investment grade bond spreads underperformed as companies issued huge volumes of debt
  • This cycle of Fed tightening is likely to be unusually slow, cautious and well-communicated

It has not felt like it somehow but 2015 has been a bear market for US and UK government bonds, with yields up around 20 to 30 basis points (bps) at most maturities. In stark contrast, European bonds have made new record lows this year – initially as the European Central Bank (ECB) announced quantitative easing (QE) and cut interest rates to negative levels, but again ahead of its upcoming meeting in December where further easing measures are widely expected. German bund yields now have negative yields out to six years, and even Spanish and Italian debt, pricing in high default probabilities as recently as 2012, trades with negative yields at the short end of the curve.

Elsewhere in fixed income, we have seen stability in most investment grade corporate bond spreads in the UK and Europe, although some event risk has come back in the market – for example, spreads in VW bonds were hit badly after the emissions scandal. US investment grade bond spreads have underperformed this year as companies issued huge volumes of debt, perhaps in anticipation of yields continuing to rise as the Federal Reserve starts to hike rates.

The US market has also seen some fundamental deterioration in credit quality – leverage has risen, partly as a result of share buybacks and mergers & acquisitions (M&A) funded by borrowing. US high yield bonds were the underperformer of 2015, continuing the damage started at the end of 2014 as energy-related bonds (rigs, pipelines, exploration and refining) started to discount a prolonged fall in oil prices. And as other commodity prices (copper, iron ore) hit their lowest levels for years, bonds exposed to metals and mining also sold off. Outside of energy and commodity names, however, default expectations remain very low.

If there was a bear market for US and UK government bonds, it was nothing compared to that in the emerging markets. Local currency emerging market debt had an awful year. The Chinese slowdown created fears for global growth, with commodity-exporting developing economies suffering as a result.

As these fears rose, outflows from developing world ‘yield tourists’ exacerbated the emerging market debt price falls. In the local currency space, many emerging market government bonds now yield more than 7% (Brazil yields over 15%) When coupled with falls in currency of 20% to 30% against the US dollar, we go into 2016 with a significant improvement in emerging market debt valuations.

Talking of the dollar, as Fed rate hike expectations grew, the US currency had another very strong 12 months. As one of my highest conviction positions for the last two years, it is time to ask whether the dollar’s valuation already reflects a world of rising US rates and slow growth elsewhere in the world.

M&G’s retail fixed interest team on December's US rate rise

After seven years of zero interest rate policy, 16 December 2015 saw the Federal Open Market Committee (FOMC) decided to raise its target range for the federal funds rate by 25 basis points (bps) to 0.25%/0.50%. The monetary authority also decided to raise the interest rate paid on excess reserves by 25bps to 50bps and raise the maximum bid for overnight repo operations by 20bps to 25bps.

The Committee justified its decision on the back of the continued strength of the labour markets and the fact that inflation, while still low, is expected to rise gradually towards the 2% target over the medium term. The FOMC also decided to maintain its existing policy of reinvesting principal and coupon payments on agency and mortgage-backed debt as well as Treasury holdings. 

During the press conference, Federal Reserve chair Janet Yellen cautioned that ‘lift-off’ was not intended to be the beginning of a campaign to raise rates quickly, but rather that the Fed would remain flexible and proceed in a cautious manner.

This increase in the key interest rate was expected, and in our view, was the appropriate decision, as detailed in our recently published Panoramic Outlook (see section headed ‘At last – wage growth’ below). In the US, labour markets are currently at record tights and core inflation has recently increased to 2% year-on-year. In addition, with the drag of oil prices on headline inflation diminishing and recent improvements in wage growth, the start of a normalisation in monetary policy was, in our view, inevitable.

While somewhat balanced, we believe the risks remain towards the upside and the Fed may need to hike rates faster than markets currently expect. That said, structural pressures on inflation and the high levels of both private and government debt in many areas of the world mean the terminal Fed funds rate – that is, the rate at which the Fed will stop hiking in this cycle – will be lower than it has been historically, probably around 2%.   

At last – wage growth

The missing ingredient in the global economic recovery since the Great Financial Crisis has been wage growth. As economies recovered and corporate profits grew, incomes have improved only modestly. Without consumers seeing improvements in living standards, ongoing demand for goods and services was likely to stagnate.

I have always said there will be a time to worry about inflation, and a time to take outright short positions in bond markets, but that time would not come until wages started to rise at a meaningful rate. As we end 2015, it is possible that moment is about to happen – that we may be at the non-accelerating inflation rate of unemployment, the ‘NAIRU’.

"Fed tightening in this cycle will likely be unusually slow, cautious and well-communicated to markets."

Economists love playing the NAIRU game. Where is it? Has anyone found it? Is it higher or lower than before? Despite the elusiveness of this theoretical concept and building block of modern macroeconomic theory, the implications are wide-ranging and touch everyone earning a wage.

As the prime theory that an economy is operating at full-employment, the NAIRU is of utmost importance to central bankers around the world. Left unchecked, an environment of rapidly rising wages can lead to higher inflation as businesses look to retain profit margins by hiking prices on consumers. It is for this reason that economists closely monitor wage price developments to see if there is any sign that labour-market tightness is leading to higher wages for workers.

In the US and the UK, we now know what the NAIRU is. With the unemployment rate close to 5% in both countries, we have now begun to see the pick-up in wages that central bankers have been waiting for as a sign their respective economies were on a self-sustaining growth trend. For the Fed, in particular, this is a big deal. Historically, a rising employment cost index (ECI) has been associated with interest rate hikes. Indeed, in the 1990s and 2000s, the Fed increased interest rates in anticipation of a pick-up in the ECI.

Given the US economy is operating at full employment, we expect the Fed is now ready – finally – to increase rates. The timing of a rate hike from the Bank of England is more difficult to call, given the uncertainty surrounding a potential referendum on Britain’s membership of the European Union in 2016. We do not think the timing of any rate hike is as important as determining the terminal Fed Funds rate (the rate at which the Fed will stop hiking) in this cycle.

Fed tightening in this cycle will likely be unusually slow, cautious and well-communicated to markets. If this is the case, then the reaction in bond markets would likely be relatively benign compared with prior Fed rate hikes. The first move of this cycle is likely to be the so called ‘dovish hike’ – rates go up, but the messaging is designed to not spook global markets.

Nevertheless, historically, Fed Chair Janet Yellen’s framework for rate rises (the ‘Optimal Control’ path) has suggested the central bank’s reaction function would be to delay the first hike for as long as possible (tick) before an aggressive, steep hiking cycle. The fragilities of the global economy make this seem unlikely, but if wages continue to accelerate we should brace ourselves for a swifter normalisation of rates than is currently priced into bond markets.

Positioning for 2016

A central bank policy member told me recently that “the least likely path of monetary policy is that priced in by bond markets”. The US interest rate futures market expects a gradual pace of rate hikes towards 2% over the next couple of years. This policymaker’s view, however, was that growth and inflation outcomes are likely to be binary.

The inflation soft patch we are in now could be symptomatic of deep problems in the global economy, in which case further monetary easing and unconventional policies will be needed. Or, if the recent wage developments are maintained, inflation could return to target sharply, and rates will need to rise much more quickly than the market expects. We think it is more likely we have reached full capacity in many areas of the labour market in the US and UK, and that there is little value in their government bonds.

If we are right, and recent wage inflation is sustainable, then we should see inflation rates heading back above 1% in the developed economies. A return to CPI levels above central bank 2% targets will take longer but, with inflation-linked bonds pricing in persistent disinflation, we want to buy them. Insurance is a better buy when it is cheap and inflation protection is no different.

In corporate bonds, it is hard to see why default rates should rise much from current levels. Fundamentals are slowly deteriorating but, outside of energy and commodity names, spreads appear to overcompensate investors for the credit risks they take.

Liquidity risks remain high though, as the corporate bond market asset growth has been accompanied by a shrinking of the investment banks’ ability and willingness to hold bonds on their balance sheets. We believe investors need to be compensated for both credit and liquidity risk, and to run more in cash and liquid fixed income instruments than they might want to purely from an investment standpoint.

The sell-off in emerging market debt and currencies looks to be the biggest valuation opportunity in global fixed income. Significant risks remain, however – both from the continued slowdown in global trade and also from domestic politics and fiscal deterioration. We have closed out our emerging market short positions but are not yet ready to be fully bullish on the asset class.

The dollar tends to do well until the Fed starts its hiking cycle. While the strengthening of the US currency is relatively modest compared with some of its previous bull cycles, and we expect it to continue to outperform into next year as the great ‘divergence’ continues, on some fundamental valuations, and taking into account heavy investor positioning in it, the upside potential is not as great as it was.

“If there was a bear market for US and UK government bonds, it was nothing compared to that in the emerging markets.” 


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