Central bank and government actions will come under increasing scrutiny in the second half of the year as fixed income investors look for further signs that the long era of ultra-accommodative monetary policy is coming to an end.
Anticipation that the European Central Bank (ECB) will begin its path to policy normalization while the U.S. Federal Reserve and the People’s Bank of China (PBoC) continue their tightening measures may bring a return of volatility as investors begin to worry about life after stimulus. In this increasingly uncertain environment, a cautious approach to fixed income will be required, focusing primarily on emerging markets and on selective opportunities in developed market companies with strong balance sheets and earnings potential.
FADING “TRUMP EFFECT” LOWERS EXPECTATIONS
When Donald Trump was elected U.S. president last November, fixed income markets sold off dramatically amid anticipation of tax cuts, regulatory reforms, and a massive increase in U.S. infrastructure spending. Trump’s difficulties in persuading Congress to back all of his ideas have dampened these expectations, and investors have begun factoring in a lower probability of the new administration delivering its original mandate.
U.S. economic data have also come in weaker than expected so far this year, with growth, inflation, and housing figures lower than anticipated and only the labor market showing clear signs of tightening.
Combined, these developments have led to a flattening of the U.S. yield curve, traditionally regarded as a sign of an economy moving into the later stages of an expansion. Identifying the exact point at which the cycle will end is fraught with difficulty, however, and it is perfectly possible that U.S. growth will pick up again before a correction takes place. While this uncertainty persists, the Fed faces the delicate task of continuing its tightening cycle and beginning to shrink its USD $4.5 trillion balance sheet without causing widespread alarm in markets. In the meantime, U.S. corporate earnings growth appears strong and defaults are not expected to rise in the near future, providing opportunities to invest in companies with sound fundamentals where attractive valuations can be found.
YIELDS TO REMAIN LOW IN EUROPE—FOR NOW
Talk of tightening in Europe should be treated with some caution. There is little chance that the ECB would risk the eurozone’s recovery with an overly aggressive move, although it may modify its language to prepare investors for the eventual tapering of its bond-buying program and, further down the line, interest rate increases and a balance sheet adjustment. If anything, the ECB may have an even more difficult task extricating itself from its accommodative monetary policy than the Fed Unlike their U.S. counterparts, ECB policymakers must consider the impact of their actions not just on one country, but on many nations with wide variations in credit quality. However, as long as the ECB avoids surprising markets with unexpected moves, yields in Europe should remain low for the rest of the year.
Political uncertainty has resurfaced in Europe in the form of the hung parliament in the UK following the June elections. While the result could lead to the UK government adopting a more pragmatic approach to Brexit negotiations, concerns around domestic policy are likely to weigh on investor sentiment. In many ways, though, Europe is in a stronger position than it was at the beginning of 2017. In the Netherlands, the anti-European Union, anti-immigration Freedom Party failed in its bid to become the largest party in the Dutch parliament in March elections, and in France, the centrist candidate Emmanuel Macron defeated the far-right Marine Le Pen in May. Economic growth is strong across the Continent, and business confidence is high, reflected in an increasing willingness to invest and hire. As in the U.S., corporate earnings in Europe are strong, meaning that opportunities exist for fundamental investors who are able to identify attractively valued corporations with strong fundamentals.
Yields should also remain fairly well anchored in Japan, where the Bank of Japan (BoJ) is likely to remain committed to its yield curve control policy. However, it is worth noting that yields in the country’s small corporate bond market have begun to rise as traders prepare themselves for the day the BoJ ceases to be the buyer of last resort. The bank has been gradually reducing the pace of its bond buying, and in May, Governor Haruhiko Kuroda discussed the possibility of exiting the current policy for the first time since it was unveiled in 2013. Any further signals of this kind could drive up volatility as investors anticipate the implications of the BoJ’s huge government bond-buying program coming to an end.
EMERGING MARKETS RALLY HAS FURTHER TO RUN
Emerging market bonds have outperformed their developed market rivals by a large margin year-to-date, leading to a surge in inflows. This has the potential to continue for the rest of the year and beyond as economic growth in the region is starting to improve, several countries are making further progress on structural reforms, and a number of local debt markets continue to offer good value. In addition, while the Fed is hiking interest rates on the back of better growth and rising inflation, some emerging market countries such as Colombia and Russia are in disinflationary cycles. This makes their local bond markets attractive even in the face of Fed tightening.
A main risk for emerging markets is the possibility that the U.S. dollar may strengthen due to further Fed tightening, which would put pressure on emerging market bonds and currencies. Any sharp declines in commodity prices also would be a concern for emerging markets, as would a heightening of political risks such as the Brazilian corruption scandal or further tensions in Asia related to North Korea’s missile program.
China also remains on the “risk radar” for many investors, as an economic slowdown there seems, to a degree, inevitable. Beijing has taken steps to crack down on leverage, and there are fears that more moves in that direction could create unforeseen problems. If that happens, the effects will be felt not just in Asia, but across the world, particularly in countries heavily dependent on Chinese demand, such as Germany, Australia, Chile, and Brazil.
Chinese authorities are likely to seek to avoid taking any drastic measures, at least until after the ruling Communist Party’s National Congress in November. Meanwhile, progress in trade talks with the Trump administration has calmed fears of a U.S.-China trade war. Medium-term prospects for local emerging market debt therefore continue to look solid, although investors need to be vigilant for signs of sharp setbacks.
GROWING RISK NECESSITATES CONTINUED CAUTION
The overall picture for fixed income investors in the second half of 2017 is one of growing risk and selective opportunity. While monetary policy divergence between different regions will persist, providing opportunities to exploit moves in spreads and the shapes of yield curves, it is clear that this theme will not continue indefinitely: The Fed and the PBoC have already begun tightening, the BoJ has tentatively started to talk about it, and the ECB may begin talking about it soon. The end to the era of ultra-accommodative monetary policy may be approaching gradually, but it is coming—and fixed income investors will feel the impact. Yields will rise and volatility, which has been artificially repressed, is due for a comeback.
Given all of this, we believe it would be prudent for investors to adopt a cautious approach to fixed income over the remainder of the year and into 2018, focusing on high-conviction positions. Local emerging market debt will offer some of the best opportunities, particularly in countries with a low inflation outlook and limited prospects of interest rate hikes. Floating rate bank loans, which have historically performed well during periods of rising rates, may also prove their worth over the coming period. Otherwise, strong recent corporate earnings growth means that investors will continue to find opportunities in global companies that have sound fundamentals and attractive valuations.
Quentin Fitzsimmons – Bond Portfolio Manager – T. Rowe Price