No bond bear market yet, but watch your Bunds

No bond bear market yet, but watch your Bunds

25-01-2018 | Quarterly outlook

Yields in the euro area are increasingly difficult to match with the strong economic uptick. Kommer van Trigt, Head of Robeco’s Global Fixed Income Macro team, expects more discussion on the ECB’s loose policy. The coming year will most likely be the first in a decade during which monetary accommodation will be reduced on a global aggregate level.

Speed read

  • Compressed yields in European core bond markets are unattractive
  • Credits are priced for perfection, which makes us cautious
  • Emerging local debt is still a buy

Van Trigt’s team expects the synchronized economic expansion to continue this year and inflation in developed markets to broadly move sideways. ‘As long as inflation remains well behaved, central banks have a window of opportunity to gradually normalize monetary policy,’ he says. ‘The business cycle in the US is already late-cycle. The aggressive flattening of the US yield curve is reflecting this. At the same time, we have learned from Janet Yellen that cycles do not die from old age. In fact, US growth has broadened now capital expenditures are finally contributing. The approved tax plan might further support capital spending.’

‘For bond investors US inflation should be top of mind,’ Van Trigt says. ‘Wage growth remains contained for now. Headline inflation will increase, driven by higher oil prices, but core inflation is close to zero if we exclude rents.’ Also in the euro area core inflation is low. ‘It has been hovering around 1% for the last four years,’ says Van Trigt, ‘and as the euro area economy is still mid-cycle we do not expect a spectacular pickup in inflation there. Meanwhile the growth rebound is spectacular and broad-based. Growth is now equal to that in the US, with producer confidence indicators at historic levels. Steady improvement across countries and sectors bodes well for economic activity in 2018. So expect more discussion on the ECB’s loose policy.’

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Global top-down bond investment framework

The figure summarizes the Global Fixed Income Macro team’s views on the attractiveness of government bond markets and specific fixed income assets, based on valuation, technicals and fundamentals.

Lower interest rate sensitivity, especially in German bonds

Van Trigt has reduced interest rate exposure in the euro area. ‘Current yield levels are increasingly difficult to match with the strong uptick in economic activity in the region,’ he says. ‘We also still prefer US Treasuries (currency hedged) to German Bunds because of their valuations. The yield spread between the two blocs is high in a historical perspective. Hedging costs have increased, but compressed yield levels in European core bond markets look unattractive versus US bonds from a risk-reward perspective. We expect the US-German yield differential to converge.’

Emerging local debt is still a buy

A global synchronized economic upturn without imminent inflationary risks is a favorable backdrop for emerging local debt. Inflows continued last year, but are not yet at pre-May 2013 taper tantrum levels. Similarly, valuation continues to look attractive, both when compared with historical levels and against other risky fixed income categories such as high yield. ‘On a critical note,’ says Van Trigt, ‘the wave of rate cuts across many emerging countries is slowing down. However, for countries like Indonesia and Brazil we still see scope for some further monetary easing. Top-down risks would be an abrupt Chinese growth slowdown and a more aggressive Fed tightening policy. Also, idiosyncratic risks such as elections in countries like Brazil and Mexico have to be managed actively.’

Cautious stance on credits, mind the central banks

The corporate bond market has been one of the main beneficiaries of the relentless central bank purchase programs and the resulting search for yield. The coming year will most likely be the first in a decade during which on a global aggregate level, monetary accommodation will be reduced. With credit markets priced for perfection, a scenario in which risk premiums will adjust is a real possibility, according to Van Trigt. ‘We hold on to our cautious stance on credits, preferring subordinated financials to US corporate high yield. Financials can benefit from the economic upturn and should also do well in case global yields start to rise.’

Preference for Spain over Italy and France

Spanish government bonds look attractive, especially when accounting for the possibility of the country returning to the A rating bucket in the course of this year. ‘We expect Italian government bonds to lag in the run-up to the Italian elections which are scheduled for March 4,’ Van Trigt adds. ‘French government bonds are now trading close to spreads versus Germany that have not been this low since 2011. Combined with a heavy auction schedule for the first quarter of this year and less QE buying by the ECB, this makes us shy away from French government bonds.’

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