The trade war threat and political risks in Italy are reasons to remain cautious on bonds. Fred Belak, Head of Robeco’s Global Fixed Income Macro team, expects bond markets to consolidate ahead of the November US elections. He is underweighting credits and remains cautious until spreads widen further.
“The US tax cut plan and the push to reduce regulatory burdens are providing strong stimulus to the US economy,” says Fred Belak. “With growth accelerating towards 4% in the second quarter, the economy at or near full employment and personal savings rates declining to low levels, the cycle can be extended with a boost from a pickup in business investment.”
“As part of the tax cut plan,” says Belak, “corporations also received favorable treatment on their offshore cash, much of which was held in US dollars. This has contributed to a tightening of global USD liquidity as capital is repatriated back to the US. With the Fed already far along on its tightening cycle, we are now in the unusual situation where the global reserve currency is expensive to borrow and less freely available than in previous years. We expect this situation to continue at least until the US economy slows, which we don't forsee anytime soon unless there will be major trade shocks.”
“We are seeing a broad repricing of the US dollar higher,” Belak explains, “and on a rolling basis selective asset markets are being re-rated lower. In a normal cycle, with the risk-free global reserve currency offering more attractive yields, we would expect riskier assets to reprice accordingly as investors rebalanced their portfolios to hold safe haven bonds. This is not a normal cycle though, as central banks for years have shrunk the supply of sovereign debt to the point where yields were so low that investors were forced to venture out the risk curves to get yield.”
“So bond investor portfolios are riskier across the world than many would like, but investors are reluctant to rebalance to risk-free assets given the still low term premiums and absolute yield levels for most safe haven bonds outside the US.”
“In the US, where the Fed stopped its Quantitative Easing (QE) program in 2014 and has begun Quantitative Tightening (QT), the process of rebalancing portfolios towards safer risk-free bonds is further along,” Belak knows. “Spreads in some markets, such as emerging USD debt, have widened enough to begin to look interesting. While fears of a trade war are affecting US investment grade credits a bit, strong domestic growth expectations have encouraged US investors to continue to overweight US high yield.”
“Likewise, the strong US dollar has also forced vulnerable emerging market countries to raise rates, as their currencies have weakened sharply. We think the emerging local currency bond market is also slowly getting more attractive. What we need to see to get more bullish on emerging markets is either an end to US rate hikes or, more likely, a re-acceleration in growth outside the US.”
“When we look outside the US,” Belak continues, “China's deliberate policy to gain more control of its financial system and deflate its credit growth that began in mid-2017 has begun to slow its economy as planned. This has predictably begun to impact Asian growth and Europe via trade linkages.”
Belak is more concerned about the risks of a sustained trade war than many other analysts. “Trump's popularity among Republicans is now close to 90%. His protectionism clearly plays well with a large part of the Republican base. This makes it attractive for Trump to continue to pursue this theme into the November elections. As a result we have moved to a neutral stance on Treasuries. Should equities sell off sharply, we would be comfortable establishing an underweight position if yields move much below 2.7%, as we continue to feel the growth stimulus in the US remains strong.”
The Italian elections and the response to the new coalition government has brought back old concerns that the Eurozone remains an unworkable currency union. “With risk premiums rising sharply in Italian debt in May and some contagion to other periphery countries, the ECB has once again moved to a more dovish stance pushing expectations for rate hikes even further out to later in 2019. We do not expect Draghi to raise rates before his term ends,” says Belak.
“The free float on privately held German bonds has shrunk to close to 10%. This has created a scarcity premium for AAA assets in Europe, with Bund real yields now reaching negative 1.25%. Although the ECB has indicated they will end QE by year end, we believe the stock effect of their QE policies will continue to cap bund yields below 80 bps. Should the new coalition in Italy threaten the euro’s integrity, we believe the scarcity of privately held Bunds could lead to sharply lower and even negative yields.”
Given the extreme financial repression in Europe, the reduction in market liquidity, and increased political risks in Italy, recent spread widening is causing concern among bond holders across credit markets. “In our view, spreads are still not at attractive levels,” Belak concludes.
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