30th April 2014
BlackRock has identified its main fixed income themes for 2014. In a note issued this week, the firm says: “There’s no doubt that fixed income markets have changed. The search for yield endures, but decades-long notions of safety and consistency have had to be re-evaluated.
At the start of 2014 we set out four key themes that we felt would drive fixed income markets forward – central bank policy divergence, deleveraging in Europe, a shift in the balance between shareholder and corporate bondholder interests and differentiation in emerging market debt. These themes have been playing out as we thought, especially our expectations for improved total returns for the asset class in 2014 following the yield curve steepening of 2013. So where do we go from here?”
We outline its view below.
1. Central bank policy divergence
The global macro environment is improving, albeit below trend and with no sign of inflation. The major central banks are at differing inflection points with respect to their post-crisis unconventional policies. The Bank of England (BoE) and the Fed appear to be establishing the blueprint for transitioning from highly accommodative to more normal policy, while the European Central Bank (ECB) and the Bank of Japan (BoJ) are considering additional monetary easing.
As they continue to quickly adjust (and further differentiate) their monetary policies, market volatility is set to rise, creating risks as well as opportunities for investors. Ultimately, an exit from quantitative easing (QE) will be extremely challenging and reducing global liquidity will have unintended consequences across all assets. For now though, we expect:
· The BoE to be the first of the world’s four major central banks to raise interest rates, potentially as early as the first quarter of 2015.
· The Fed to continue to place a greater emphasis on the path of both inflation and the labour market while it tapers; wage growth will be watched closely. The front end of the US yield curve will remain highly sensitive to monetary policy volatility, either from Fed communication or data improvement, while the long end is supported.
· The ECB to remain accommodative, given ongoing questions over further potential policy options and the strength of the euro. The results of this year’s Asset Quality Review will be assessed ahead of any contemplation of its own version of QE. Core European government bonds have outperformed the US and may now be vulnerable, especially if investors turn out to have placed too much hope in monetary policy action. European peripheral spreads have continued their strong compression; while further moves will be difficult, economic momentum will remain supportive.
· The BoJ to press on with its unprecedented monetary easing policies, leading the yen lower still. Government bond yields may start to become vulnerable if economic growth meets or exceeds the authorities’ expectations. QE expansion could come in the third quarter of this year.
2. Europe is deleveraging
The leverage cycle in Europe looks very different from the US, where corporates are already re-leveraging and merger and acquisition activity has picked up significantly. In Europe the deleveraging of the financial system continues, and is already changing credit markets and creating new opportunities for investors, for example in new instruments like the AT1. Opportunities include:
· Newly open areas of capital markets where banks have pulled back from doing business.
· Increasingly popular instruments like contingent convertible bonds (or ‘CoCos’) where banks have issued new securities to re-structure their balance sheets.
· Covered bonds help exploit recovery stories in certain companies and, by extension, certain countries.
The deleveraging of the financial system, and the resulting negative net supply, continues to inform our preference for European financials over industrials, a view that has performed well so far this year.
3. Finding the balance – bondholders vs shareholders
The overall environment for credit remains benign given low corporate default rates and plenty of liquidity. However, as we highlighted at the start of the year, we are seeing an increase in event risk, particularly in the US. Companies are taking advantage of attractive funding levels to take on greater balance sheet risk and reward shareholders through dividends, share buybacks or engage in M&A. US investment-grade corporate issuance is currently running 16% ahead of last year’s pace, contrary to consensus expectations that it would be lower.
· The overall investment grade space now looks expensive, but there are plenty of company-specific opportunities.
· Investors should consider sectors with less event risk such as US mortgages.
· In high yield, carry is available but with more caution. Fundamentals remain solid, but spreads are nearing 2006-2007 lows and much of our 5-6% expected annual return has already been achieved.
4. Spotting the differences in emerging markets
Emerging markets debt (EMD) assets have been in sharp focus since the Fed began tapering its QE spending last year and concerns over China’s economic trajectory increased. This was most obvious in February this year when the coalescence of these global issues with unrelated emerging markets-specific events like geopolitical crisis in Ukraine, unrest in Thailand and corruption scandals in Turkey saw EMD assets sell off again.
However, some EMD countries are gradually repairing their fiscal and external balances, and EMD fundamentals are slowly improving with significant currency-led adjustment in the more fragile countries such as Indonesia and India. Although many country spreads have, with the exception of Russia, reached pre-tapering levels, low net supply of hard currency debt is supportive. As we highlighted in January, EMD remains cheap relative to developed market credit. Hard currency debt is one of the best-performing fixed income markets this year; while the spread compression will slow, it provides a much needed source of yield for fixed income investors.
We are, however, moving from an era of indiscriminate buying in which EM countries and assets moved in unison, to one requiring much greater differentiation and a deeper understanding of each and every country. Context is everything, especially in local rates where FX-driven volatility remains a risk.
· EM bonds to outperform their developed world counterparts over the long term.
· Performance to be driven more by fundamentals and local, idiosyncratic factors and less by portfolio flows.
· A big dispersion between countries in terms of investment returns, monetary and fiscal policies, and economic fundamentals.