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The absence of wage inflation should not prevent bond investors from being watchful. In a world of expanding economic growth and upbeat markets, central banks are likely to continue with the gradual normalization of their policies, says Kommer van Trigt, Head of Robeco’s Global Fixed Income Macro team. US Treasuries and emerging local debt offer pockets of value.
US bond yields have moved up to the upper half of this year’s tight trading range (2%-2.6%). “Solid economic activity data and speculation that Donald Trump’s high level tax-cut plan will get traction and spur growth and investment were behind this move,” says Kommer van Trigt. “For now, the US economy is still cruising along at a 2%-2.5% growth pace like in the past years, but a breakthrough in Washington could potentially bring a 3% growth number in sight,” he says. “This, however, is not our base case scenario. Then there is the question who will become the new Federal Reserve chair. The candidates that Trump is considering differ quite a bit in terms of profile and therefore market implications. And there is of course the unpredictable reaction function of Trump relating to North Korea.”
On the global inflation front, the big debate why falling/low unemployment levels don’t translate into higher wages continues, while the actual data do not show meaningful price pressures yet. “It is not a given, though,” says Van Trigt, “that wage inflation will remain dormant until eternity. The latest US labor market report gave some hints that underlying wages pressures are firming. Bond investors should be watchful and flexible here.”
“To us it makes sense for central banks to move on with gradual policy normalization, with world economic growth on an upward path and market sentiment buoyant,” Van Trigt continues. “As long as inflation remains contained, there is a window of opportunity to do so without disturbing the interest rate environment too much.”
Van Trigt sticks to his preference for US Treasuries over German Bunds, based on valuation considerations. “The yield spread between the two blocs is high in a historical perspective. Compressed yield levels in European core bond markets look unattractive versus US bonds from a risk/reward perspective (currency-hedged). We expect the US-German yield differential to converge. We also increased our interest rate exposure in 30-year German bonds at the cost of 10-year bonds. This part of the curve is really steep, also compared with other highly rated government bond markets.”
Whereas many fixed income segments look expensive, emerging local debt still offers value, according to Van Trigt. “Real yields are attractive versus developed markets, driven by past monetary tightening and falling inflation in many emerging countries. Several central banks are currently easing monetary policy and we added exposure in a couple of these markets such as Indonesia and Brazil (the latter currency-hedged). We also remain bullish on Mexican local rates (currency-hedged). Continued inflows into the asset class are supportive and cumulative inflows are still below the pre-taper peak. Key risk to monitor is the outlook for monetary tightening in the US. A more aggressive stance by the Fed could lead to disappointments.”
“We have shifted our opinion on Spanish government bonds from a cautious to a constructive stance. We are positive on Spanish fundamentals and the spread widening following the Catalan referendum offers a good entry point. We continue to hold an underweight position in Italian government bonds due to the likely upcoming deterioration in the political situation as political parties start campaigning for the general elections in early 2018. The first hurdle will be the local elections on the Island of Sicily at the beginning of November, where polls show a significant lead for the populist M5 movement.“
Solid economic growth and moderate inflation are supportive for credits, but valuations have become even richer. Van Trigt regards high yield credit as the most expensive sector, both at an absolute level and relative to investment grade. “History does show however that in the current stage of the economic cycle stretched valuations can persist for quite a while.”