Our three scenarios developed at the beginning of the year – more of the same, bouts of volatility and a bond bear market – were sympathetically received with most people I spoke to attaching a fairly low probability of the third one, given that there is very little expectation that the Federal Reserve will suddenly turn more aggressive before the end of 2014.
This was also the conclusion of our forecasting session this month which took place against a backdrop of heightened geopolitical risks and more evidence of the difficulties China will face in slowing its economy to a more sustainable pace of growth.
Bonds have been pretty unfazed by these events and it is looking like Q1 total returns will be better than we expected at the beginning of the year. Up to the 27 March, according to data from the BofA/Merrill Lynch bond indices, the US Treasury market has delivered a total return of 1.79%, Bunds 2.86% and gilts 2.64% – pretty good considering there were many worries about rates going higher.
The rally in rates has boosted credit returns as well with investment grade outperforming government bonds by 30bps to 80bps and high yield doing even better, outperforming government bonds by 170-180bps year-to-date.
Oh, did I mention that these returns are, on the whole, better than those from equity markets so far this year?
Developed markets will lead global growth
The US is expected to expand around 1% more quickly than in 2013 and the Euro Area as a whole should exit recession, while the UK is likely to lead the growth table expanding at a pace of more than 3%.
While there have been some doubts about the US picture in recent weeks our view is that some improvement in data flow is likely. Certainly investors must consider that global monetary policy remains very accommodative, that the negative impact of fiscal tightening on growth is diminishing as austerity eases and government deficits decline, and that private sector balances are healthy, with the household sector benefitting from rising house prices in many countries.
It’s not a boom and there are still elements missing from the growth story – namely a meaningful pick-up in private capital expenditure spending and stronger real wage growth – but generally macro volatility is expected to stay low, with momentum positive.
On balance, according to our internal scoring, this is a slight negative for core government bonds in the US and UK, and a positive for credit and high yield.
Rates: higher or lower?
The second macro theme is what I term "reluctant monetary activism". Central banks don’t want to do much. The Fed and the Bank of England (BoE), having ditched version 1.0 of forward guidance, have been reluctant to give the market any impression that they are close to raising interest rates.
There has even been some backtracking on Janet Yellen's comment that the Fed would start to raise interest rates six months after the end of tapering. Now central banks are hiding behind a multitude of economic indicators which has made monetary policy less transparent than it was under quantitative easing (QE) or even under the "threshold driven forward guidance" of last year. They don’t want market rates going up yet and luckily, they haven’t thanks to low inflation and some risk aversion related to Russia and China.
As far as the ECB is concerned, it thinks inflation will bottom out soon and therefore there is no need to take any immediate anti-deflationary action. However, it is also not ruling anything out and the interest rate bulls were encouraged this week by comments from the President of the Bundesbank who said that QE was not completely out of the question. It was suggested to me that the ECB might do something in April ahead of the May European elections.
An interesting thought and I’d never really given much weight to the idea that the ECB would take such things into consideration. But maybe the timing is right, given the positive momentum in the economy at the moment and the need to try and reverse the strength of the euro.
If we roll forward and if our view on the path of economic growth is right, the market will start to price in higher US and UK rates more aggressively later this year, the ECB may do something to lock in lower rates for longer, and the euro/dollar exchange rate might just head back to $1.20 or so.
At any rate, the divergent monetary policy outlooks between the US and UK on one hand and Europe on the other supports the general stance to be underweight US Treasuries and gilts and overweight European government bonds.
Inflation
Related to the interest rate outlook is, of course, what’s happening with inflation. It is low and it is lower than most people expected. Moreover, inflation momentum has been trending down. Disinflation concerns are most acute at the moment in the euro area.
There is a global element to this – the commodity price cycle and the strength of the euro – but there is also a structural element within the euro area that has to do with the rebalancing of competitiveness after the euro crisis.
Spain reported today that its consumer price inflation rate fell to a provisional – 0.2% in March. This is deflation but it also represents a necessary adjustment of costs. Since the launch of the euro, Spain has had an accumulated 19.6% increase in its consumer price index relative to Germany.
Without the option of devaluing the currency within a single monetary zone, countries have to internally devalue by having lower wage and price inflation. With Germany itself reluctant to have inflation much above 2%, other countries have to have inflation below that level, which means the average for the Euro Area is going to remain low for some time. Of course if it gets worse, the ECB may have to act.
It's not over until the deflation risk recedes – Commodity prices have risen so far in 2014 (as referenced by the CRB index) and this may help put a floor under global headline inflation rates. We have taken the view that this will be the case and, as such, retain a somewhat positive view on break-even spreads in the inflation linked bond market, especially in the US and the UK.
The longer term break-evens remain well above current inflation rates but we are at an unusually low point in the inflation cycle and if that persists central banks could even revert to the most aggressive policy tools in their kit bag – QE again. That is not the central view but it is clearly important to monitor the inflation numbers going forward.
Emerging risks
I have a simple view here of the context of the current problems for the outlook on emerging markets. There have been a number of cycles over the last 40 years or so that have been characterised by strong capital inflows to emerging markets: the US bank lending to Latin America in the 1990s, the carry trades in Asia in the 1990s and the more recent strong portfolio flows into emerging market stocks and bonds, which received a turbo boost from QE in 2010.
In their own ways these episodes created excessive credit growth, external imbalances and a reduction in competitiveness through overvalued real exchange rates. The bubble always bursts and then there are periods of rebalancing.
I would also say that today, the fundamentals are much better than they were in the LDC debt crisis of the 1980s or the Asian crisis of the 1970s – on many levels including government finances and macroeconomic policy making. Economies are stronger too, in terms of their economic infrastructure, wealth and productivity. The long-term story remains compelling – given the demographics, resource availability in some countries, and the fact that growth need not be encumbered by ‘old’ technology.
However, we are in one of the phases of post-credit growth adjustment. This means macro policy adjustment – higher rates, lower currencies – and adapting to a higher cost of capital as external finance becomes less easy to get. China is central to this and I have written before that it is likely to be a source of headline risk as the economy moves to a new growth model.
Having said all that, we see value in emerging market debt, particularly the hard currency sector where spreads above US Treasuries are more than double those of US investment grade bonds.
Chris Iggo is CIO of fixed income at Axa Investment Managers
