Fixed income monthly strategy update - December 2015
Global multi-sector strategies, UK and European credit strategies.
Monthly review and outlook
- More detail in the global policy outlook was shaded in over November. Government bond markets diverged to reflect the differing expectations for headline interest rates.
- Treasuries were weaker while gilts and Bunds advanced. Investment gradebonds were relatively flat while the oil price again weighed on high yield.
- The key themes for the portfolios have been finalised. The new themes broadly reflect the increasing influence of central banks and the fallout of the extended period of extreme policy accommodation.
- The environment is not conducive to large scale directional trades, and we have adjusted the portfolio accordingly.
Policy forecasts for key central banks firmed again in November, with the clearer outlooks reflected in bond market movements. The Federal Reserve (Fed) looks increasingly likely to raise the Fed funds rate in December, stating that “it may well become appropriate to initiate the normalization process at the next meeting”, notwithstanding any unanticipated shocks. The Bank of England meanwhile, referenced persistent concerns over China’s economic progress in striking a more dovish tone. The European Central Bank (ECB) reiterated its commitment to policy accommodation, with President Mario Draghi stating that ECB policymakers will “do what [they] must” to return inflation to target.
The 10-year Treasury yield rose, following the Fed’s comments, from 2.14% to 2.21%. Shorter dated yields rose more aggressively, leading to a flatter yield curve. The 10-year gilt yield fell from 1.92% to 1.83% and shorter dated gilts declined more modestly. In the eurozone, the 10-year Bund yield fell from 0.52% to 0.47%. Peripheral government yields also declined, with Italian and Spanish two year yields dropping into negative territory.
In corporate bond markets, the investment grade BofA Merrill Lynch Global Corporate Bond index generated total returns of 0.1%, while the high yield equivalent index fell by -1.2%. The weakness in global corporate bonds markets in November was due to weakness in US dollar credit. Euro and sterling corporate bonds – both high yield and investment grade – generated positive total returns in November.
In emerging market debt, the JP Morgan EMBI Global Diversified index fell -0.1%. This is a ‘hard currency’ sovereign index, which tracks emerging market bonds traded in less volatile US dollars. The local currency JP Morgan GBI-EM Global Diversified Composite index fell -2.2%. In corporate bonds, the hard currency CEMBI Diversified Broad Composite fell -0.5%.
Stance and outlook
Looking to 2016, we expect that the global economy will remain broadly stable. The US and the UK look robust, with softening manufacturing sectors currently propped up by a more active consumer. In the eurozone, growth is much more tentative, but we believe it will persist given the explicit commitment from the European Central Bank to offer support. China then, stands as the remaining puzzle amidst major growth drivers.
Having conducted in-depth research on China and its prospects, the multi-sector strategic view is that China will continue to slowdown. This is to be expected of a huge economy transitioning from infrastructure and manufacturing led growth to a more sustainable service model. The transition will be extended, and a high degree of uncertainty remains, but the political will of the government to complete it appears to be resolute.
A stable global economy however, does tacitly equate to global market stability. The (warranted) investor perception of global central banks being integral to financial market health means that these institutions will continue to loom large over market movements in 2016. Our worry is that the communication strategies of major central banks have been inconsistent in 2015. We anticipate that volatility, until greater clarity is restored to policy outlooks, will be characteristic of markets in the coming year.
Corporate bond markets may offer a degree of shelter from the murky policy environment. Both US dollar and euro investment grade corporate markets have grown cheaper during the year and on a selective basis, opportunities are available. High yield corporate bonds are even less exposed to policy changes, and as with investment grade bonds, the volatility and risk aversion of the third quarter has reset valuations to the point that certain areas look attractive. Commodity-sensitive sectors, particularly in the US, represent a range of prospects, but we would advise caution on issuers linked with metals production.
Key investment themes driving strategic decisions:
- Central banks are highly influential in financial markets, and this is leading to high levels of market distortion.
- Oil prices are likely to rebound as the supply glut is choked off by falling capex spend. Metals prices are not likely to enjoy the same readjustment as the fragility is attributable to structural demand weakness.
- The business cycle has been extended by low inflation, low interest rates and low energy prices. The strength of the consumer is prolonging the inevitable transition into a period of slowing growth.
- China should continue to slow, but we do not expect a collapse that could trigger a new financial crisis.
The portfolios continue to use a themes-based approach to positioning.
- Financial markets are, and have been for some time, dominated by the influence of central banks. Whether via quantitative easing, the management or manipulation of currencies, or through forward guidance, central banks played a massive role in financial markets in the wake of the global financial crisis. However, while the overall aim was to provide stimulus and ensure that transmission mechanisms were effective, the by-product has been a high degree of market distortion. We saw the relevance of this theme in effect through the market reactions to Fed comments in September and October. This is, however, not just a US issue; central banks globally have arguably kept rates too low for too long. Market distortions and periods of market volatility are likely to remain in play.
- The lower oil price has had a depressive effect on inflation for over a year. However, we believe two things are underappreciated by the market. The first is that the initial price weakness was supply-led, and not principally due to a deterioration of demand. The second is that the sustained oil price weakness has led capital expenditure (capex) on exploration and production to dip. We expect that the second point will, in 2016, partially mitigate the effect of first as supply begins to fall again. The fragility in metals prices, on the other hand, is underpinned by a structural waning of demand. We expect the rebalancing of China economy to affect metals demand for some time.
- The business cycle has become atypical, in that traditional relationships between economic and financial variables are being challenged. As a further function of the high level of global policy accommodation, the business cycle is being stretched out. The ratio of return on investment to cost of capital has begun to fall, and although this is currently being offset by consumer strength, this would otherwise indicate an advanced phase of the cycle. We do not foresee a recession within the coming 12-18 months but, again, expect volatility to build periodically.
- As China’s economy transitions from one led by exports and fixed asset investment to one generating sustainable growth from domestic consumption, we expect it to continue to slow. That said; we do not expect China to collapse. The government has both the political will and the policy tools available to avert a ‘hard landing’ and with it any ensuing financial crisis. However, China also has excess capacity in the industrial and goods sectors which is being removed, causing some disinflationary pressure. This makes sector allocation more important, with some areas more sensitive to the protracted deleveraging process than others.
In addition to the macro drivers of thematic trades in multi-sector strategies, we also focus on broad reaching credit related themes to build new ideas. These will often be extension of, or variations in, the multi-sector themes.
- We believe the aggressive economic growth targets for China are unsustainable. The commodity supply chain to China is therefore under threat, and heavy machinery is vulnerable to excess capacity. Sales to China account for a high percentage of margins for many companies. We have enacted these views with underweight exposure to issuers with material revenue dependency in China and emerging markets; such as raw materials, machinery suppliers as well as consumer good and financials.
- A high degree of consolidation between the telecoms and media sectors, as well as reforms in healthcare, has driven M&A activity to rise. We favour post-M&A companies that are undertaking deleveraging as well as leveraged target companies.
- Retailers with weaker brands are vulnerable to more efficient e-commerce giants. Strong brands are better able to protect margins. Our aim is to identify and focus on issuers with a strong online presence, with exclusivity. We are positively disposed to distribution centre real estate and cautious of retail real estate.
- Consumer tastes change rapidly; fashion and technology suppliers have become increasingly disrupted by the trend. We are wary of slow-moving product cycles.
- Disinflationary pressures are detrimental to real earnings. We are cautious around highly leveraged or capital intensive businesses. German issuers are particularly exposed to the capex cycle and these headwinds.
Important Information: The views and opinions contained herein are those of Michael Lake, Investment Director, Multi Sector Fixed Income,
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