Outlook 2017: Global bonds
2016 looks like a year for the history books. Will we ever again see so many of the world’s government bonds offering negative nominal yields?
At its most extreme, for a short time in July and August, every Swiss government bond between 1 and 50 years was below the magic zero rate of return. Good for the Swiss government, considerably less good for the Swiss saver.
Perhaps unsurprisingly, the collective central bank community became increasingly worried about their growing market impact and have increasingly encouraged governments to contribute a more equitable share of the economic heavy lifting.
At the same time there has arguably been a shift from panic to complacency over the outlook for China. Meanwhile, President-elect Trump has suggested he has heard loud and clear the calls for a more assertive fiscal response. This has all resulted in 10-year yields ending the year in many of the major bond markets at similar levels to where they started the year. Quite a round trip by most investors’ standards.
However, the world remains far from fixed and considerable uncertainties remain. These include what the UK government’s strategy is on Brexit, a high degree of uncertainty about just how far the rise in populism will run in Europe and most recently what exactly President-elect Trump’s plans are for his trading relationship with the rest of the world.
2017 could be another rollercoaster year for bonds and foreign exchange. While we have all fastened our seatbelts, below are the tentative conclusions we draw from our strategic analysis of economics, politics and what markets currently discount.
Passing the baton
Lower and lower official interest rates coupled with ever increasing amounts of quantitative easing (QE) were designed as a kick-start to consumption.
Unfortunately central banks underestimated the reticence of consumers (both household and business) to use the additional windfall from lower mortgage and interest costs to go out and spend or invest.
What they believed was a sprint has turned into something more akin to a marathon. The rethink of policy mix became increasingly urgent as QE started to look as though the cost / benefit trade-off was swinging away from benefit towards ever increasing potential cost. Perhaps it coincided with a rise in populism, but it certainly helped the wealth divide become increasingly obvious and probably push back the need for structural reform in many parts of Europe.
Outside of the US no fiscal bazooka
Central banks became increasingly vocal about a need for greater stimulus in final demand. In the absence of consumers or business, the obvious candidate to bridge the gap between demand and potential supply was government spending. With government debt offering the cheapest financing ever, central banks increasingly vocalised their view that governments should loosen the shackles and stimulate the economies through fiscal policy.
However, global debt may have become cheaper to finance but the amount outstanding remains prohibitively high to allow a fiscal bazooka. While Donald Trump may dispute his ability to spend, his own Republican party will most likely temper the US’ most ambitious spending plans since the global financial crisis.
We will no doubt see some of the heavy lifting done via government spending but a bazooka given the fiscal dynamics seems wide of the mark, even in the US.
Structural concerns have faded but remain in the background
China continues to spend beyond its long-term means. Meanwhile, many emerging economies have yet to find a new growth model to replace a growth engine built upon ever-increasing levels of consumption by Western consumers, or ever-increasing demand of commodities from China.
The pace of structural reform in Europe has slowed to a crawl. The UK seems to be struggling to find a palatable negotiating strategy for a post-EU world and Japan remains stuck in a low growth-low inflation setting.
While bond yields may continue to creep higher as central banks attempt to wean economies off QE and record low interest rates, it is far too premature to normalise policy.
Don’t confuse cyclical with structural
What we believe we are currently seeing is a cyclical upswing clearly assisted by easy monetary policy and a bit of a fiscal shot in the collective arm which may continue to tame yields. However, central banks will be cautious about removing policy accommodation prematurely and are more likely to take greater inflation risks which, rightly or wrongly, they believe they can bring back under control.
Where are the opportunities?
Clearly given our view that 2017 could be another rollercoaster ride, we expect to adopt a more opportunistic trading strategy. Break-even inflation (the difference between the yield of a regular government bond and an inflation-linked bond of the same maturity), which has moved higher post Trump’s victory still has room to move higher, especially if Trump follows through on his “America first” rhetoric and becomes more protectionist.
The US dollar probably has room to move a little higher but here we need to be increasingly selective on whether we express a bullish US economic view through the US currency or a more defensive stance towards US government bonds (duration). The two are clearly linked.
With regards to corporate bonds, the potential change in tax structure suggests US companies may actually shy away from debt financing, which is obviously a positive sign for investors in both investment grade and high yield (non-investment grade) corporate bonds.
But above all else, the world is no longer as synchronised economically as it was in the days leading up to the global financial crisis or the last seven or eight years. With globalisation taking a back seat it’s most likely we see greater economic divergence between the world’s major developed economies and within the developing world clear divergence between those that find a revised business model and those that don’t.
While we are unlikely to see a return to the extreme negative real and nominal yields seen over the summer, it’s also unlikely we will see the yields investors became accustomed to before the great financial crisis began all those years ago.
The rollercoaster is alive and kicking. For an active fund manager, it will be an interesting but potentially rewarding ride.
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