The US has begun to reduce its bond buying programme, evidence that the economy is picking up although the rhetoric is still one of caution. In Europe, recovery is tentative against a backdrop of low inflation and employment but with uneven expansion across sectors and countries, plus structural adjustments and political risks weighing in.
We believe that three major potential scenarios could play out in 2014:
1. Risk-on continues, supported by forward guidance and the hunt for yield.
High returns are likely to be rare in this scenario – high yield could reach 5-6%, possibly higher in emerging market debt (EMD), as it remains unloved, but EMD should recover if risk-on remains the driver of investor behaviour.
2. Something happens to cause a market correction where spreads widen and equities drop.
It could be a growth or earnings disappointment, a resumption of European worries, an emerging market collapse or some other unpredictable event. We believe risk spreads are not wide enough to compensate investors for a sudden shock.
3. Strong economy, inflation coming back and yields much higher.
I would wager that this may not leave spreads and stocks unscathed, so the bond market could have a double effect of higher risk-free rates and credit spreads.
What is currently unfolding is a dominant scenario – number one. Even as global healing resumes, we are entering the next phase of tapering, which is all about policy makers talking down any expectations of interest rate rises.
With a core scenario of increasing government bond yields and tightening credit spreads, in the AXA WF Global Strategic Bonds we maintain a low duration, less than three years’ exposure and our biggest allocation remains in high yield, albeit off its highs of year end 2013.
One of three
While market positioning is consensually in scenario one (i.e. short duration / long credit risk) it makes us think that scenario two is increasingly likely. The outright bearish bond scenario (three) is in our view the least likely.
For example, in our view high yield is still appealing in comparison to government bonds and investment grade, but we are being selective and more cautious. The euro high yield market returned approximately 10% in 2013, but now valuations in parts of the market look stretched. New issuance surged in the latter part of 2013 but with a number of quality names issuing with weaker covenants.
We believe it is likely that we are coming towards the end of a very strong run and invariably towards the end of a cycle where there will be periods where many investors buy more risk at the wrong price. We are not there yet but some caution is required. I would describe is as “less constructive” rather than “outright bearish”.
As high yield becomes expensive, core government bonds or better quality credit may become attractive again. Currently, people have become so bearish on government bonds that they have been almost ignored regardless the price, but 2014 could be the year where gilts, bunds or treasuries come back into favour, maybe if only for short periods of time.
