The roadmap for fixed income
Navigating the current landscape is a bit like driving a car – you need to remain vigilant to anticipate the traffic pattern ahead whilst keeping an eye on your dashboard – the speedometer, your fuel gauge, the temperature and the rev meter. Let’s look at the main metrics to watch:
Global economic growth is essentially going at the speed limit. Not accelerating too fast but slowly gaining ground. G10 economic growth is marginally above trend and expectations in the market are that lower growth going forward will be the norm.
The US Federal Reserve is gradually taking their foot off the pedal and winding down quantitative easing, whilst the Bank of England will be moving to hike interest rates late this year or early next year. Nevertheless, there remains a huge amount of money going into the global economy, especially as Bank of Japan and European Central Bank continue their policies. And when you consider the market’s rate hike expectations, the trajectory for the ultimate level of rates is much more shallow than in previous cycles, meaning that tightening is likely to remain modest. This means there remains plenty of fuel from monetary policy to bolster risk assets.
Inflation is the factor to keep an eye on here. We’ve seen a pick-up in core CPI in the US but long- term inflation expectations really are not elevated. Global central banks have said they are happy to let core headline inflation go slightly higher than expected. Meanwhile, actual wage inflation is the core metric that could really stimulate further economic growth and it remains modest as there is still a lot of slack in the labour market.
Investors need to keep an eye on potential overheating. It is true there are areas getting slightly warmer, such as UK housing market. Prices are up significantly the UK housing market, but overall lending is still relatively low. Bank of England is doing what they can on taking macro prudential measures to adjust the possibility of a bubble without interrupting the economic momentum.
Now that we’ve taken account of the dashboard, what does all that mean for fixed income investors in determining the road ahead?
In our view, the dashboard is giving us a green light. Broadly we’re constructive on credit and are continuing to allocate to high yield across US and European markets. If we look at spreads and defaults in Europe, it’s similar to the US at about 3.5 per cent, some way off the historical lows. We think low spreads are sustainable as default rates remain below or around 1 per cent and we think the asset class is further supported by rates remaining low for longer in the Eurozone.
Interestingly, spread as a percentage of total yield has never been as high historically. In that sense, the spread is attractive in relative terms and the credit quality is compelling. We’re seeing a lot of high yield rated companies being upgraded, which functions as a positive technical impact. An example would be French investment company Wendel. As these upgraded companies fall out of the high yield index, investors have to rotate their allocations accordingly. In our estimate, as much as 15 per cent of the European market could become so-called ‘rising stars’ in the coming years. As they move through into the investment grade category, this will act as further support to market prices.
Meanwhile, we are finding interesting opportunities in the European banking sector. The decline in leverage ratios and increase in capitalisation are both positives for bond investors. The most attractive areas in our view are down the capital structure, so security selection is important here. When we look at contingent convertible bonds for example, we rely on bank analysts to seek those companies that have a history of calling bonds as a factor in security selection. We also look for cash flow generative banks that can give some assurance on the coupon.
When we look at the emerging market opportunity set, from a technical perspective we’ve seen flows into the asset class stabilise and investors re-engaging. This may represent investors covering underweights and getting back to neutral on the asset class, hence we think it is sustainable. Also, we think the emerging market inflation outlook seems relatively benign.
Whilst emerging markets debt looks optically attractive with a local currency index yield of roughly 6.5 per cent, there is significant underlying divergence between countries as well as a large element of currency risk. In our view, it is a tactical opportunity that requires an alpha-driven approach. For example, we have liked and continue to like short dated Brazilian bonds, which are yielding about 11.3 per cent. The central bank appears to be on hold and the Brazilian Real has sold off significantly last year following the ‘taper tantrum’. Over the last few months that has stabilised, which makes the yield look more attractive.
Iain Stealey manages the JPM Strategic Bond Fund.