Outlook 2015: Global Bonds
Volatility in bond markets was conspicuous in its absence through the majority of 2014. Although market commentary was laden with indications of surprise – at the ongoing compression of yields, the degree of policy accommodation or dramatic swings in macroeconomic data – market volatility remained curiously stifled. However, September and October offered something of a reality check. With the Federal Reserve (Fed) ending quantitative easing, as well as resurgent fears over global growth, volatility has made a comeback.
With volatility in bond markets likely to continue its comeback in 2015, opportunities for fixed income investors will emerge.
While some investors have viewed this as a cause for concern, we believe that as the monetary policy environment becomes more normal, a natural escalation of volatility from recent lows is to be expected. Furthermore, volatility is central to generating outperformance, and its recent escalation has not significantly altered our expectations for bond markets in 2015.
Is tightening approaching?
The US economy is growing at a healthy rate, and should continue to strengthen. Stronger employment has fed through to higher levels of consumption, and from here we expect that wage growth should begin to escalate. Inflation and wage growth have remained low in recent prints, given the downward pressure on key inputs like the oil price. However, we expect that lower oil and fuel costs will ultimately prove a boon to consumption, and this will trickle down into rising wages as the Fed’s oft-quoted “underutilisation of labour resources” is used up.
All of this adds up to a well-supported case for a tightening cycle by the Fed. We believe that interest rate markets currently underestimate the probability of rate hikes by mid-2015. We also expect volatility – which has been suppressed by low base rates and quantitative easing (QE) – to begin to close in on higher historic averages over the course of the next year.
In the UK, the period of robust growth momentum appears to be moderating, with the cooling property market and a weaker eurozone likely to dampen economic expansion. Nonetheless, domestic growth is – and will remain – sufficient to continue to close the output gap and tighten the labour market. While there are some structural factors which will curtail the ability of the Bank of England to impose lengthy and severe rate hikes, interest rate markets expect a later and slower hiking cycle than we do.
The eurozone remains fragile
The problems in Europe’s economy, meanwhile, have grown dire. Confidence has taken a further hit following the slowdown in German data, while regional inflation continues to flirt with the all-important 0% level. The crisis between Russia and Ukraine, as well as China’s softer growth numbers, have taken their toll on German industry. That being said, we believe that markets in Europe are more reflective of current events than either the US or the UK, and that the majority of the economic pessimism has now been priced in.
The announcement of the European Central Bank’s programme of Asset Backed Securities (ABS) and covered bond buying is being treated with scepticism, with few investors confident that the scheme is large enough to make a real impact on the economy. There is growing consensus in markets that sovereign QE will be announced in 2015, although political hurdles remain high. We favour sovereign exposure in the eurozone over US Treasuries, and believe that the spread of southern European sovereign bond yields over German bunds could tighten further when QE is announced. In this scenario, we also expect to see further weakness in the euro.
Emerging markets offer opportunities and hidden dangers
Within the broad emerging market space, our view is that value is challenging to find overall. However, rises in volatility tend to affect emerging economies in more pronounced and varied ways than developed markets. This can give rise to some isolated opportunities in long maturity sovereign debt. The current weakness in commodity prices provides a supportive environment for Asian markets, but has hurt Latin America. There are also some opportunities where central banks have hiked interest rates to support their currencies. However, with local currency bonds, investors need to be mindful of the potential for currency risk in emerging markets, which can cannibalise returns very quickly.
We feel it is important to highlight - given our expectation of higher volatility – that going forward all but the most liquid asset classes will be increasingly difficult to exit during times of market stress, owing to changing bank behaviour and regulation. Care needs to be taken to ensure that portfolio positioning and trades sizes are appropriate to compensate for any periods of diminished liquidity.
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