With many expecting a ‘great rotation’ out of fixed interest assets in 2013, bond investors will, in the main, have experienced a better year than some had predicted 12 months ago.
Riskier assets, notably high yield corporate bonds, have continued to perform strongly, while investment grade corporate bonds are on track to deliver another year of positive returns, in spite of the volatility.
Meanwhile, the macroeconomic backdrop has generally improved over the past year, although the picture remains mixed. However, all countries – and all bond markets – are united by at least one common dependency: the Fed.
After the great taper debate
While investors might have started 2013 unfamiliar with the concept of ‘tapering’, the same is certainly not the case here in 2014. Markets were in thrall to the ‘will-they-won’t-they’ nature of the great taper debate since its introduction in May right up to its affirmative decision in mid-December.
We saw during this time, from the reaction of bond yields around the world to taper speculation, that no country is immune to the Fed’s decisions. We would, however, caution against now getting overly pessimistic towards government bonds.
Inflation is currently benign and, in addition to the US, central banks around the world will only gradually remove monetary stimulus. Interest rate hikes are still likely to be on hold for some time, limiting the potential for a big bear market in bonds.
In our 2013 outlook, we set out our positive view of US growth prospects. One year on, and regardless of tapering, the reasons that led us to be optimistic – including an improving current account balance and steadily falling unemployment rate, as well as a rebounding housing market – remain in place.
In turn, we are bullish for 2014 on the US dollar, where in addition to these positives, compelling valuations following a decade-long slump and the rapid move towards energy independence remain equally valid as well.
Having previously favoured the dollar against emerging market currencies and commodity currencies, after its weakness in the third quarter of 2013, we like it against all other major currencies, too.
Tapering may have begun, but we think various considerations make it likely that the upcoming scaling-back process will be gradual. The Fed will obviously want to see that the economy remains on track after bumps such as the recent government shutdown.
We must also not forget that tapering means purely a reduction in, and not an end to, stimulus. The Fed wants to make it absolutely clear that a rise in interest rates is likely to be much further off.
Even so, volatility in US Treasury markets and a rising US dollar could have a big impact on emerging market bonds. We have been cautious on the asset class for a couple of years, as we are concerned that the bubble that has developed there is under threat due to historically tight valuations, deteriorating fundamentals and better prospects for the dollar. Tapering activity could potentially lead to huge outflows, the very real risk of currency and/or banking crises, and widespread contagion.
Inflation: a vanishing phenomenon?
One topic has baffled central bankers, bond investors and economists since the financial crisis: inflation, or the lack thereof. According to conventional wisdom, inflation is always and everywhere a monetary phenomenon, causing fear that the extraordinary monetary policy of recent years would trigger rampant inflation across the developed world.
More than five years have passed since the global economy was plunged into crisis and developed world inflation appears remarkably under control. In fact, central bankers’ current concerns centre on inflation being too low – something likely to remain the case in 2014.
We see one simple explanation why the massive increase in money supply has not created higher inflation: it has not entered the real economy. Commercial banks are flush with cash but are not making many new loans. Fortunately, it appears that banks may now be starting to relax their lending standards, although it is still hard to find creditworthy borrowers, particularly in peripheral Europe.
If we do start to see a pick-up in loan growth, this will likely indicate a strengthening in the quality of economic growth. However, bond investors should not be complacent. Central bankers’ greatest fear is that banks’ reserves could flood into the economy, resulting in higher prices and unanchored inflation expectations. It is at times like these that investors must be at their most vigilant.
Should inflation re-emerge, central bankers will face a huge policy dilemma. At M&G, we have frequently mooted ‘central bank regime change’ – the shift away from targeting inflation towards boosting economic growth (and which therefore assists in eroding large debt burdens) – as a reason to own assets such as inflation-linked corporate bonds and floating rate notes. The risks of a monetary policy error have never been greater.
The outlook for bond markets in 2014
Government bonds: As we begin 2014, financial markets are clearly in better shape than a year ago. But this is not due to strong data or a long-term resolution of the European debt crisis. Most regions still face significant challenges, including very high levels of public and private debt.
But with inflation expected to be muted and central bank rates likely to remain ultra-low, the environment for government bonds will be relatively benign, despite higher yields and tapering-driven volatility.
Whilst there will be pressure on longer-dated government bond yields to increase, we would caution against becoming too bearish on the asset class, given that the short end of the curve will likely remain well anchored at current levels. Policy will stay highly accommodative, despite a slowly improving growth outlook.
Corporate bonds: Corporate bond investors have experienced some excellent returns in recent years. The asset class has also benefited from low volatility and broad-based inflows. While spreads are heading back towards long-term averages (see figure 1), we believe the fundamental outlook remains positive. With inflation not an issue, and growth in the developed world recovering, defaults are likely to stay low.
However, investors must recalibrate their expectations for investment grade corporate bonds as excess returns are likely to be lower in 2014. While we believe most parts of the credit market will struggle to deliver much more than their coupon, credit remains in favour versus other, even lower yielding, fixed income assets.
Meanwhile, global high-yield investors have enjoyed fantastic returns in recent years. For us, high yield can be an attractive place to generate returns in a time of improving economic growth and low defaults.
But the current benign credit environment has led to a deterioration in issuance quality, weaker structural protections, the return of pay-in-kind (PIK) bonds and lower coupons, which has resulted in lower future expected returns.
We believe in some cases, particularly for lower quality high yield, credit spreads are not adequately compensating investors for the possibility that defaults could rise.
Relative performance will therefore increasingly be driven by single-name credit calls, and sector positioning will also become more significant. It is more important than ever for bond investors and their credit analyst teams to do their homework.
Emerging market bonds: The potential re-pricing of US monetary policy is clearly the most serious risk facing global emerging markets. Outside this, we expect developments in China to dominate.
We think some investors may still be underestimating the risk of a slowdown in China’s economy, which remains imbalanced: almost 50% of GDP comes from gross fixed-capital formation, up from a third in 1997.
We think that regardless of Beijing’s reform path, more corporate defaults, non-performing loans, and some degree of a credit crunch are unavoidable over the next three years. China will still grow, but closer to 5%-6% than 10%.
Any China slowdown would likely lead to a drop in emerging Asian currencies. Implementing capital controls to stem outflows could arrest the slide, but this is unlikely, given the long-term damage this would do to investor confidence.
Tapering will remove a key support from the emerging markets. Rising bond yields and expectations of reduced asset purchases would likely drive the US dollar higher, hurting emerging equity markets and driving credit spreads wider. Meanwhile, any large-scale wobble in global investor sentiment could reverse the massive inflows of recent years.
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