Tale of two Debts

In aggregate, the bond asset class remains expensive. Government bond yields are too low to tempt a meaningful increase in duration exposure, credit spreads are so tight that it is difficult adding credit risk especially when most fixed income investors are already overweight credit relative to rates.

So the market is a little directionless at the moment, with minibouts of volatility stemming from the trials and tribulations of the Washington soap opera. In the meantime, the additional carry from owning corporate credit is likely to be where most investors look for return.

At the end of March the prevailing view of our fixed income team is that government bond yields have not increased enough for us to be comfortable in extending duration in bond portfolios and that credit spreads need to move away from very tight levels in order for us to feel comfortable adding credit risk. In other words, bonds are still very expensive. Sadly that is expected to remain the case for some time for two main reasons. The first is that the Federal Reserve (Fed) has done a good job in stabilising bond yields by being very open about a slow and steady approach to raising interest rates. So even though rates are expected to keep on rising until well into 2018, long-term bond yields are actually at the same levels today as they were at the beginning of the year. The second reason is that, despite the credit cycle being quite long already, there is little evidence of either a deterioration in asset quality or a destabilising increase in leverage. Consequently, credit risk premiums are low across the ratings spectrum and across developed and emerging markets. In addition, the “Trumpflation” trade has lost a little of its “oomph” and while expectations of deregulation and fiscal stimulus are still significant contributors to investor sentiment, their influence has diminished in recent weeks. That means in bond markets, the appropriate tilt is still to be short duration in terms of interest rate exposure, and more positively exposed to corporate credit and inflation protection There is little point adding aggressively to this stance. It may be that carry is the key driver of return in the next couple of months.

Bored of uncertainty

There are plenty of things that could change that of course. The problem is that they are “known unkowns”. The French election, the timing and implementation of the Trump legislative agenda and how China deals with the consequences of a slower medium term growth path all generate a degree of uncertainty. But they have for a while and unless the uncertainties crystalise into “known” outcomes, their impact on sentiment is rather diminished. While markets have had a little wobble this week I would be surprised if it turned into a serious rout (although this may depend on the FBI). As such, volatility should remain low going into the Easter break and until the serious run-in to the first round of the French Presidential election. Even on Brexit, no meaningful sense of how the negotiations between the UK and European Union (EU) are developing is likely until well after Easter. Given the awful events in London on Wednesday afternoon more prosaic considerations are perhaps best given less attention.

Peripheral vision

As always, for our European bond portfolios, we consider the prospects for the “peripheral” European government bonds. It has generally paid off in recent years to have an overweight position in the bonds of Italy, Spain, Ireland and even Portugal, relative to the lower yielding German, Dutch, Austrian and Finnish core. The reduction in the spread has been driven by the European Central Bank’s (ECB) bond buying and Mario Draghi’s assertion that he would do whatever it took to save the euro. However, today the absolute yield levels are not that attractive with the short-end of the Irish curve in negative yield territory and Spanish and Italian bonds yielding less than US Treasuries. In thinking further ahead one has to consider a number of things that could impact on the valuation of these peripheral bonds. One is the general increase in yields that is likely if the global economic and inflation cycle continues to firm. The second, and perhaps more important, is what happens when the ECB starts to exit its own super-accommodative monetary policy position. What happens when the ECB stops buying government bonds? In my opinion we have to consider the very real risk of another sovereign debt crisis.

Poor debt dynamics

Why do I say that? In short because debt levels remain very high and higher yields will significantly reduce the ability for governments to stop debt levels rising further. Italy is the country that stands out to be of greatest concern. Its growth rate is poor with nominal GDP growth in 2017 only expected to be 2.0%, according to the OECD. The International Monetary Fund (IMF) estimates that Italy’s government debt is set to be 133% of GDP this year – a level that is some 34 percentage points higher than it was at the end of 2007. If growth is weak and borrowing costs can’t be reduced any further, the only ways left to reduce debt are to generate a large budget surplus or to restructure. The latter has not been a politically plausible option and the former has not been done enough. Italy’s government budget has been in a small primary surplus (excluding interest payments) but the OECD estimates that it slipped back into deficit in 2016 and will remain so this year. The political impasse prevents significant reforms being undertake that might generate a higher tax take or reduce structural spending so no real progress is being made in terms of improving debt dynamics. In addition, there is a large contingent liability that is the banking sector and its stock of low quality assets.

Irish eyes are smiling

The Italian story contrasts very differently with that of Ireland. Ireland’s debt shot up as the government had to bail out the housing and banking sectors post-2007 and by 2012 it was very close to the same level as a percentage of GDP as Italy’s (123%). However, since then it has fallen sharply and is expected to be at 73% of GDP in 2017. Taking the pain upfront in terms of domestic austerity and bailing out the banks allowed the Irish economy to recover more quickly. From a 10% drop in GDP in 2008, the economy is now seeing real growth in the region of 7%. Inflation is low but the expansion has allowed debt to decline sharply as a percentage of GDP. The primary budget is in deficit to the tune of around 1.0% of GDP and these positive metrics have been rewarded by very low borrowing costs for the Irish government – the yield on the benchmark 10-year bond is just 1.07%. Any shock coming to the Irish economy is not going to be one necessarily caused by the end of the ECB’s quantitative easing (QE) but one that results from any dislocation to trade with the UK as a result of Brexit.

Need for more growth, higher inflation and continued low rates

Ireland does not only compare well with Italy, it compares well with most of the rest of the G20. The average debt/GDP ratio for the G20 countries, on the IMF definition, is set to be 116% this year with the US at 108%, the UK at 88% and France at 97%. These levels have mostly been unchanged since 2012 onwards. Very few countries have been able to benefit from the combination of stronger growth, low borrowing costs and improved budgetary performance. Greece, which has had the most austerity and has had some of its debt haircut, is still highly indebted despite generating a primary budget surplus of 4% of GDP. Spain has done reasonably well in terms of economic restructuring and restoring competitiveness and growth is now better. However, its debt ratio remains largely unchanged since 2014 at around 100% of GDP. The point here is that large parts of the world economy still need more growth, still need more inflation and are still constrained in their use of fiscal policy because of the need to balance the books. That is, of course, if they want to bring their debt/GDP levels down. Sovereign crises have been avoided because much of the funding of government debt has been achieved, indirectly, through quantitative easing and when or if this ends there is bound to be upward pressure on borrowing costs again. It also raises the question of just how far central banks are able to increase interest rates. Higher rates will lead to increased government borrowing costs and eventually an economic slowdown all of which tends to increase government budget deficits. At some point, global bond investors, will have to pay far more attention to specific country risk than they do at the moment because some sovereigns will become very stressed. Add the overlay of political populism and anti-EU sentiment and the medium term risk levels rise even further. Taking into account primary budget balances, debt to GDP levels and debt dynamics (growth relative to borrowing costs) the countries that come out on top are Australia and New Zealand and the Scandinavians. Oh, and wasn’t Norway just named as the happiest place to live?

Scant reward in government bonds

In the major economies, government debt to GDP levels have continued to rise. Another crisis might bring even more radical attempts to deal with the problem – restructuring, the creation of a federal debt market in the euro area or outright cancellation of debt held by central banks. These are longer term issues. Today government debt yields are very low except for the likes of Greece and Portugal. Even without the longer term concerns about sovereign credit risks, the asset class offers little value unless it is seen from the perspective of capital preservation during periods of risk aversion. Our asset allocation remains tilted towards “spread” products where there is an additional risk premium above the government yield curve – be it inflation or credit spreads. If bond prices don’t change, an investment grade portfolio in Europe will provide you with 1% more return than a core government bond portfolio. In the US that extra return is 1.2% and in the high yield market it is more than 4%. Against a backdrop of stable growth, that extra carry is still worth going for.

Chris Iggo – Chief Investment Officer, Fixed Income – AXA Investment