Bond markets are extremely sensitive to any upside surprise in US inflation expectations. Still, price levels and leading inflation indicators give no reason for imminent concern. We expect a mild upswing in long-term bond yields in the course of this year, driven by central banks’ policy normalization. We are most positive on emerging local debt and the European periphery.
Evidence is growing that international investor flows into US fixed income are stalling. Rising hedging costs are part of the explanation, as short-term interest differentials between the US and other parts of the world continue to rise. Japanese investors are switching their government bond exposure back to Europe again. European and Japanese investors are reconsidering their holdings in US corporate credits after years of relentless buying.
Is the market’s obsession with the US inflation outlook justified? Yes and no, is the unsatisfactory answer. Actual price levels and leading inflation indicators give no reason for imminent worries. Federal Reserve Chairman Jerome Powell also recently pushed back against the notion that the US economy is close to overheating. So that’s the no.
At the same time, it is very rare and potentially counterproductive for US fiscal policy to be so expansionary this late in the business cycle. Or to put it differently: “Sometimes it’s better never than late”. The combination of an unemployment rate only just above 4% and a budget deficit surpassing 5% this year, urges every fixed income investor to be on guard for an inflation lift. The last time we had this potentially toxic combination was during the Vietnam War... Markets are extremely sensitive to any upside surprise to the US inflation outlook and we believe this will not change anytime soon. So that’s the yes!
After a significant sell-off in the first weeks of the year, bond markets started to consolidate towards the end of February, especially in the euro area. A cautious European Central Bank (ECB) and some indications that growth in the region was about to stabilize (albeit at high levels) drove long dated bond yields even below the levels that prevailed at the start of the year. However, we continue to believe that central bank policy normalization will gradually push up term premiums in the course of this year.
The continued increase in hedging costs for US fixed income securities is gaining traction as an investment theme. We therefore no longer prefer US Treasuries to German Bunds.
As it looks now, Powell will continue Yellen’s gradual normalization of official target rates. A hiking trajectory of roughly 25 bps per quarter should be bearable for emerging local debt, assuming the US dollar remains weak. Valuation looks appealing, especially for emerging currencies. Real rates are still significantly higher than the zero or negative levels in 2013 just before the taper tantrum.
Emerging markets’ external vulnerability looks more contained now, as inflation is structurally lower, current accounts have adjusted and currency reserves have grown. Finally, while recent inflows into local emerging debt have been significant, they have come from a low base and therefore positioning looks far from stretched.
Ever since the stock market correction took off in early February, credit spreads have widened at a gradual, but steady pace. Year-to-date excess returns are in negative territory for most subcategories. Within the credit spectrum we are still constructive on subordinated financials, but it is clear that these high beta bonds are not invulnerable in a more volatile market environment. We continue to prefer European to US credits and have fully hedged our exposure to corporate high yield.
Notwithstanding the recent correction, credit markets still look priced for perfection. The global synchronized growth environment is supportive, but debt levels, especially for US corporates, are a source of concern.
Year-to-date, peripheral government bonds have come out as the top performing asset class, with total returns close to 2% (Italy, Portugal) or even more (Spain). We envisage this strong performance to continue, driven by strong economic growth throughout the region and new initiatives on the political front that will further spur euro area integration. Positioning doesn’t look to be excessive as investors had scaled down exposure in the run-up to the Italian elections. Another positive from a technical perspective is the large amount of redemptions in April, as the ECB will fully reinvest its maturing bond holdings.
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