The best of times or the worst of times?
6th January 2017 by Chris Iggo
Economic momentum is improving. It is supporting risk assets and delivering good returns to investors. Can it last? It can if the Federal Reserve (Fed) does not need to raise rates too quickly, if the new US Administration can deliver on tax cuts, if corporate animal spirits are revived and if Trump shuts down his Twitter account. For bonds the adjustment in the rates term premium should continue, albeit at an un-alarming pace. This means credit can still outperform somewhat. However, fixed income remains expensive and a more bullish risk exposure needs to wait until yields and credit spreads are significantly higher than they are today.
- Hope – Are these the best of times, or the worst of times? An age of wisdom or of foolishness? An epoch of belief or incredulity? A spring of hope or a winter of despair? Dickens’ famous opening lines to “A Tale of Two Cities” seem very appropriate at the beginning of 2017 as we face the prospect of stronger global economic growth and the return of animal spirits at the same time as increased geo-political risks mostly coming from the Twitter account of Donald Trump. Markets have been on a strong run since the US election, pumped by the prospect of fiscal stimulus in the United States and by the broad based upturn in many indicators of global economic activity. Yet, the year-ahead outlooks produced last month were littered with discussions about potential risks to global political and economic stability. Over the holiday season alone there were worrying signs of how the President-elect’s style could unsettle international relations and investor confidence – the “I’ve got more weapons than you” spat with Russia, digs at China and public criticism of the United Nations over its resolution on Israeli settlements. As well as Trump we face electoral uncertainty in Europe, the mess over Brexit and ongoing terrorist related risks that are likely to continue to disrupt travel and tourism in many parts of the world. Still, if we look at markets, hope is prevailing over fear. The Dow Jones Industrial Average is flirting with the 20,000 level, the FTSE-100 is at a record high, credit default swap indices are at their lowest levels since the middle of 2015 and emerging markets bond and equity markets are closing in on pre-US election levels.
- Momentum – There is little doubt the global economy picked up momentum towards the end of last year. Just consider the levels at which purchasing manager indices were reported for December. The US ISM index was at 54.7, its highest level in two years. The eurozone manufacturing index was at 54.9, and the Chinese purchasing manager index continued to show a strong recovery. More esoteric indicators, such as the Baltic Dry Index (a measure of shipping freight rates), also suggest a pick-up in world trade. In the UK, despite the political chaos surrounding Brexit, the economy is doing much better than expected with the composite purchasing manager index at 56.7 in December, an 18-month high. This strong momentum in the economic data is likely to bring some upward revisions to GDP forecasts for 2017 and will put a strong floor under interest rate expectations, especially in the United States. The minutes from the December meeting of the Fed’s Open Market Committee suggest that policy makers are not only taking a more positive view of where the economy is today but are also starting to factor in the potential additional boost to growth that could come from the new Administration’s fiscal stance. The Fed’s median forecast for the Fed Funds rate stands at 1.35% for the end of this year and 2.15% for the end of 2018. So unless there is a rapid deterioration in the economic data, the process of rate normalisation will continue, even more so in the context of late-cycle fiscal stimulus.
- Normalisation – The normalisation of monetary policy is so far just a US trend. Yet it is enough to stimulate the return of a term risk premium in bond markets. Indeed, this is the key theme at the moment. So far, it is quite benign with yields stabilising a little at the beginning of 2017. There has also been evidence of the benign negative correlation between government bond yields and credit spreads, a state of affairs characteristic of a positive growth period. Rising yields and narrower credit spreads, US high yield spreads are around 100 basis points (bps) narrower since the election while 10-year US Treasury yields are 60 bps higher, support the stance to be overweight credit in fixed income. Not that credit is cheap, far from it, but it is less expensive on a relative value basis than pure rates exposure. Credit spreads are roughly at levels 130% above the recent lows (mid-2014) but well below the highs reached a year ago when there were genuine fears of a global recession as a result of the collapse in commodity prices and fears about the Chinese economy. I believe that the environment for credit is still benign, with improving growth supporting stable to stronger corporate earnings and default rates remaining very low, but the prospect of significant outperformance is less than it was in March 2016. From the end of March to the end of 2016, US high yield outperformed government bonds by 15%, US investment grade by 4.4% and euro high yield did 7% better than a government benchmark. The starting point today is at credit spread levels that are much tighter and therefore the potential for these kinds of excess returns being repeated is less.
- Rotation – That means that in our view, a fixed income portfolio still has to be focused on limiting downside as we go through the adjustment in (mostly interest rate) risk premiums in bond markets. This suggests keeping duration exposure quite short and focusing on carry opportunities in the markets – with high yield and emerging markets providing the best of these in the short term. A potential playbook for bonds over the next year or so is that rates keep on rising as the US economic upturn spreads to other parts of the world and this at some point translates into much tighter financial conditions. If economic growth then starts to falter we will have a situation where credit spreads start to widen. This can happen quickly, as we saw last year. The playbook would thus be keep duration short as rates rise, gradually reduce credit exposure as spreads reach tighter levels, then look to add back duration as evidence starts to emerge of the cycle peaking and finally buy credit risk again when spreads have widened. Putting numbers on this is never easy but Treasury yields above 3% might be the trigger for the rotation back into government bonds.
- Hedging – Of course it may not be as simple as following a textbook evolution of the business cycle (rates higher, slower growth, weaker credit). Risk-off could be driven by political events and I am sure all readers are familiar with the long list of potential episodes of discomfort that we face. Some investors might want to consider some tail-risk hedges in this context, given that the cost of hedging has been falling over the last few weeks. For example, the current level of the 5-year European crossover CDS index is 289 bps relative to a 2014 low of 219 bps and a Q1 2016 high of almost 500bps. The VIX equity volatility index is currently at 11.66 relative to a 2014 low of 10.00 and a Q1 2016 high of 28.5. Hedging risk is not free but it is currently cheaper than it has been for a couple of years. This may prove opportune if the ‘Tweeter in chief’ ramps up his rhetoric in the months ahead.
- Reflation – At the end of last year the bond team at AXA IM took the view that rates would keep on rising into 2017, that credit spreads would remain relatively stable in Q1 and that inflation break-evens would rise further as actual inflation data picked up. That remains the view. The one asset class that has surprised recently has been emerging markets where the hunt for yield has propelled spreads tighter and credit indices back to their pre-election levels. There are reasons to be positive on emerging markets – higher commodity prices, improved macroeconomic governance, a better outlook for China – but there are clearly risks around trade protectionism from the US. The emerging market sovereign index is trading with a spread over US Treasuries of 330 bps at the moment, down from the 385 level after the election. But a year ago it was over 500 bps. Like other fixed income asset classes, emerging market bonds are not that cheap. There is one reason why this may remain the case – not just for emerging markets but for all bond asset classes – and that is Japan. The Bank of Japan will keep on pumping money into the economy, keeping long-term Japanese bond yields at zero or below. So Japanese investors will look overseas and, even with higher FX hedging costs, it still makes sense to invest in US dollar debt relative to the Japanese yen. Those flows will be a major technical factor in fixed income markets in 2017.