Outlook 2018: Global bonds
In many ways we end 2017 as we began. Markets are pretty cheery, stockmarkets are at or near all-time highs, growth is good, central bankers seem reasonably content, tinkering at the margin, and corporate profits are humming along quite nicely. It has been another good year for market beta or, in other words, going with the trend.
The question most investors are considering for the forthcoming year is: "can we hope for another relatively smooth year of positive returns and what, if anything, will upset the bond market stupor?"
Chart 1: Declining yield volatility - just how low can it go?
Source: Bloomberg. Merrill Lynch Option Volatility Estimate (MOVE) Index as at 24/11/2017 (measuring the volatility of US Treasury yields, the level of fluctuation in yields, using one month options contracts).
So what are the potential storm clouds and how seriously should they be taken in the construction of a robust portfolio?
Cloud 1 - Late cycle
Looking at the developed world, the first major economy to pull itself out of recession post the global financial crisis was the US. A typical US economic expansion, post-Second World War, has lasted around six years. However, perhaps because of the introduction of inflation targeting central banks, since the 1990s, the average length of an expansion phase has increased to a little under eight years.
The National Bureau of Economic Research (NBER) determines that the last US recession ended in June 2009, a little over eight years ago. To date, the longest US expansion was the 10 years ending in March 2001 with the bursting of the dot-com bubble.
By most measures the current expansion is long in the tooth. The end of an expansion phase is certainly not good for corporate profits and by extension corporate bonds (debt issued by companies), but is often a good time to be invested in secure government debt. However, economic expansions do not normally die of old age. The end usually occurs either because the central bank raises interest rates too much, or because debt fuelled excesses have built up and borrowers, whether corporate or households, begin to miss repayments.
With interest rates globally near cycle lows it seems unlikely that the glacial pace of tightening of monetary policy occurring in the US and UK will bring about the next recession. Perhaps because of memories of the financial crisis, the bulk of households in both the developed and developing world have been fairly cautious in increasing their borrowing.
So, while it is clear that this expansion is long lasting, the usual signs of fatigue appear to be missing.
Cloud 2 - An ill-timed fiscal splurge
Most of the Western world is witnessing a significant rise in support for more populist economic policies. Redistribution of wealth, or - in its simplest form - governments increasing spending on improving people’s living standards, is a growing priority.
However, redistribution of wealth tends to mean taking money from savers or tapping accumulated wealth. This arguably disincentivises work ethic and with it productivity. Increasing government borrowing risks a greater interest rate being demanded by holders of government debt, driving up the cost of financing to all borrowers and thereby acting as a brake on economic expansion.
Given unemployment in many countries is falling and in some is near or at all-time lows, a significant boost through a large tax cut or other type of fiscal injection may risk pushing an economy from comfortable acceleration into an overheated state. Overheating economies are usually met by a much faster pace of interest rate rises than otherwise would occur, carrying the risk of driving the economy into recession.
While Donald Trump clearly has a goal of transforming the US tax regime, the natural checks and balances of the political system will probably curtail its magnitude. In the UK, despite calls for a giveaway budget, it appears to have been relaxation at the margin rather than a dramatic shift in policy.
In both Japan and southern Europe the authorities would no doubt like to be less thrifty, but here again we see any easing of the fiscal reins as being at the margin.
Overall, a dramatic shift in fiscal policy seems unlikely, and so too a significant need for a dramatic change in pace in the tightening of monetary policy.
Cloud 3 - A problematic rise in inflation
To us, the most likely cause of a rise in volatility is inflation rising more sharply than anticipated. Inflation expectations globally are anchored at arguably too low a level. Though there are structural reasons to believe the world today is less prone to an inflation problem, we think these low expectations could be an example of the market’s tendency to extrapolate too much of the past into the future.
The global output gap (the difference between economic output and total output capacity) is much smaller than it was even last year given the strong growth environment. Without something to slow the global economy, demand for labour, commodities, goods and services will begin to outstrip potential supply and start to bring about prices simply through weight of demand pull.
With markets discounting a very shallow hiking cycle, if inflation (price rises) were to make an earlier than forecast return, such a shift would almost certainly bring about a repricing of both interest rate expectations and volatility. Both would likely be troublesome for markets priced on the richer side of equilibrium.
However, for now, it is a risk rather than our central case. While we believe we need to watch it carefully, we remain cautiously optimistic on the outlook for the global economy and risk markets.
Hedging the risks of higher inflation will come in many forms and be a part of our portfolio but for now our expectation is the storm clouds will fail to wash away accumulated returns from the post crisis bull market.
Even if we are past the point of maximum stupor, for now it appears appropriate to stay engaged in bond markets.
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