Outlook for global bond markets – Steeper yield curves and upside in EM

Chris Iggo, CIO Fixed Income at AXA Investment Managers (AXA IM), discusses the short-term outlook for global bond markets highlighting the importance of the upcoming US presidential election and its resulting impact as well as current positive trends in emerging markets (EM).

Key Points

• The result of the UK referendum brought fears of a negative shock to the UK and euro area economies. Monetary policy was subsequently eased in the UK and market expectations are for further stimulus in the euro area.
• However, the marginal impact on yields going forward is expected to be lower. Moreover, markets are considering what other policy tools might be used to boost growth and inflation. Mostly these lead to expectations of steeper yield curves.
• Credit spreads are stable, but markets face significant risks in the coming months, mostly on the political side. The US election is key and we will re-visit our asset allocation before that event.
• Valuations in fixed income remain rich and momentum towards lower yields has faded. As such, in our view, the focus should be on what can be seen as ‘protection’ strategies, including limiting duration exposure, on income from higher yield, on diversification into emerging markets and on seeking inflation protection where it is cheap.
• Structured credit markets face intense competition for assets but CLOs and leveraged loans continue to provide a significant yield advantage relative to fixed income assets.
• The overall tone is to limit risk as we are wary of “taper tantrum” type moves in rates and event related risk in spread products.

Questioning the rule of central banks
The policy debate – The core medium term issue for bond investors concerns the outlook for the overall macroeconomic policy mix. For some time there have been concerns that monetary policy is reaching its limits and that some aspects of the policy mix have negative implications for financial stability and economic behaviour. For example, negative interest rates and very flat yield curves are not helpful for the economics of banking and insurance sectors. Moreover there is some evidence that household savings behaviour is reacting to lower rates in an inverse way. In addition, many economists are calling for fiscal policy to play a greater role in boosting growth and inflation in developed economies. Low long term bond yields provide governments with the opportunity to increase borrowing in order to invest in long term strategies to boost productivity – infrastructure, technology and education. The multiplier effects from fiscal policy are understood to be greater than is the case with monetary policy, thus allowing growth and inflation targets to be met with more certainty.
Still QE – However, we do not expect much policy change in the short run. The European Central Bank (ECB) and the Bank of Japan (BoJ) have acknowledged that they face diminishing returns to policy and significant operational and other constraints. However, the broad thrust of policy is likely to remain a dominant theme in bond markets.
Nevertheless, the biggest impact of global monetary stimulus on bond markets is now behind us. Further declines in yield levels will be hard to sustain as the ECB struggles with increasing its bond purchases, the BoJ shifts towards a steeper yield curve target and the US Federal Reserve (Fed) continues to debate whether it needs to raise interest rates or not. As such, we do not expect significant further total return gains from interest rate moves.
Rates – We are more concerned about increases in yield resulting from the reduced impact of further central bank policy moves, the risk of Fed tightening, upside potential for inflation and some fiscal stimulus in 2017.
Credit – Monetary policy in the euro area and the UK is more focused on corporate bond purchases. This is a strong technical influence on credit markets and should prevent spread widening. We see modest scope for tighter investment grade spreads.
High yield and emerging markets – High yield continues to benefit from the search for yield and the fact that central bank eligible assets in investment grade markets are becoming very expensive. Defaults remain modest and net refinancing is manageable.
In our view, emerging markets are a strong bet at the moment as a result of fundamental improvements in key economies and relatively attractive valuations.

Macro volatility is low
Calm – Although growth remains too low for central banks and inflation is well below target in most developed economies, the post-financial crisis recovery continues. Factors that were a drag on growth in 2009-2014 have dissipated somewhat – fiscal austerity and aggressive de-leveraging – while the more recent weaknesses around low commodity prices have also become less of an issue. Yet there is still little confidence that economic growth can continue to accelerate without monetary policy support or, in the case of the United States, whether the economy is robust enough to sustain future rate hikes. As such we expect policy to remain supportive.
This implies little change in our core macro view. Growth should pick up a little in 2017 (2.2% in the US compared to 1.5% this year), according to the Bloomberg consensus of forecasts. Emerging economies are expected to show a little more upside with growth reaching almost 5% next year after two years of below trend growth. For emerging economies growth will be closer to trend while for most advanced it will still be lagging trend growth, meaning the closure of output gaps will not happen quickly, especially in Europe.
Inflation is forecast to increase next year, largely because of higher oil prices. The move higher in the UK will be stronger because of the decline in sterling.
US – The consensus is for the US economy to finish 2016 with a 1.5% growth rate (we expect 1.7%) and to accelerate modestly to a 2.2% growth rate in 2017. This is a long expansion and there are some signs of ageing – the low level of unemployment and increased leverage – yet inflation remains low, as do interest rates. Our key medium term outlook for the US depends on the outcome of the presidential election in November. The uncertainty that would be generated by a Trump victory could create increased volatility in the dollar and the bond market but the key development for the macro outlook would be on the fiscal side. If Trump delivered on promises to increase spending on defence and cut taxes to the corporate sector and the middle classes, then the Federal budget deficit would likely increase. This would mean increased issuance of Treasuries and higher yields, but it may also mean faster GDP growth and inflation. However, none of this will really become clear until at least the State of the Union address in January.
Recent data has shown some softening in manufacturing with the ISM dipping over the summer. However, domestic demand remains moderately strong with jobs growth still averaging above 150,000 per month.
Clearly the majority of Fed voting members are still hesitant in concluding that the economy is strong enough for another hike in rates. However, we do expect another 25bps increase in the Fed Funds rate in December.

Optimism on the growth outlook is hard to find – Brexit not really hit the UK or Europe yet
Economic forecasts for the UK were revised down sharply in the immediate wake of the EU referendum but have since moderated as the economy has held up well in the short term. However, most observers agree that the real shock to the UK and European economies from Britain’s exit is still ahead of us. The problem is we do not know either the time table of the exit nor the conditions on which the UK and Europe will co-exist in the future. A hard Brexit will impact on UK and European firms so it seems likely that, despite posturing, any future agreement will try to maintain a mutually beneficial trading regime whilst addressing the UK’s particular concerns about free movement – concerns that are shared in other European countries and are likely to be central to election campaigns in Germany and France in 2017.
In the short term the focus is on boosting growth and inflation and quantitative easing (QE) is expected to continue in both the UK and euro area. We believe that the potential for additional fiscal stimulus is greater in the UK at this stage than it is for euro area countries. This may ultimately mean a greater risk premium on UK assets given that the fiscal situation is not great (budget deficit of over 3.5% of GDP). In Europe, some fiscal slippage is likely but we are not sure that an actively promoted fiscal boost is on the cards. As such, the burden of supporting growth will remain mostly on the shoulders of the ECB.
Japan – The BoJ has recently committed to a more aggressive inflation target but consensus forecasts
continue to suggest that consumer prices will remain largely flat going into 2017. Growth is expected to be a little stronger but again this may rely on more aggressive fiscal policy from the Abe government. Monetary policy is now focussed on achieving the twin objectives of inflation and financial stability – through trying to maintain a positively sloping yield curve to help banks and other financial institutions. It is hard to see much upside risk in the Japanese growth outlook.
Emerging markets – The EM world continues to be the area of most optimism, at least in the short term.
Turnaround stories in Latin America (Brazil, Argentina), structural reforms (Mexico, India), a stable US dollar and interest rate outlook and firmer commodity prices have helped boost confidence in emerging markets.
Clearly an aggressive trade policy under a Trump presidency in the US would be worrisome, but for the time being we see upside momentum in growth and a stabilisation of inflation. This provides scope for some monetary easing in many of the larger economies.

Chris Iggo – CIO, Global Fixed Income – AXA Investment Managers (AXA IM)