The recent equity sell-off and dramatic spike in volatility is, in our view, a wake-up call for investors that strong global growth and falling unemployment marks the beginning of the unwinding of the QE-era.
Synchronised global growth and rising inflation expectations will most likely encourage central banks to abandon the extraordinary monetary policies that have dominated financial markets over the last decade. Core interest rates and bond yields, led by the Fed and Treasury market, are moving higher and will likely be accompanied by greater dispersion in asset performance and market volatility. But the fundamental underpinning of growth-sensitive risk assets – an improving global economy and corporate earnings – remains intact. We think that a long risk and short US duration bias is the most appropriate mix in our multi-asset credit strategies as we transition to the end of the QE-era.
Tactical asset class perspective (3-6 month outlook)1
1 ‘Tactical asset class perspective’ summarises the broad short-term tactical asset allocation views of BlueBay’s Asset Allocation Committee and positioning across BlueBay’s flagship ‘blended’ asset class strategies. The solid boxes reflect weights across asset and sub-asset classes (these ‘weights’ are indicative and do not relate to specific funds). The arrows indicate a shift in our tactical asset allocation since the previous Asset Allocation Navigator (4th Quarter 2017 published in October 2017).
As we forewarned in our 2018 Outlook, the investment regime is transitioning from ‘goldilocks’ – faster economic growth, super-easy monetary policies, and low volatility – to the post-QE era characterised by higher nominal and real interest rates, volatility episodes and greater dispersion in asset performance. The dramatic sell-off in equities and spike in market volatility in response to rising rates at the beginning of February, in our view, underscores that the transition to the post-QE investment regime will not be painless.
Credit and emerging market debt have so far proved resilient to volatility in equities, with spread widening modest by the standards of previous sell-offs. Core government bonds have not acted as a hedge against the equity sell-off with Treasury yields in particular continuing to move higher affirming our view of higher rates as the principal threat to risk assets during the transition to a post-QE investment regime. In our multi-asset credit strategies, we are retaining our short US interest rate duration bias as an offset to our long risk positioning.
Despite the drop in equities and higher core rates, financial conditions remain growth-friendly. Economic and credit fundamentals are underpinned by the synchronised global upturn, rising corporate earnings and falling default rates. Consequently, our outlook for credit and especially emerging market assets remains constructive. We believe, higher growth will likely win out over higher core rates, but the ride will be much bumpier than in 2017.
European companies continued to reduce leverage through 2017 and to a lesser extent in the US and default rates are low and falling. Nonetheless, credit spreads are tight and the scope for further compression is limited against the backdrop of higher market volatility, with the notable exception of the debt of European banks that are benefitting from improving asset quality and higher rates. In our multi-asset credit (MAC) strategies, we have chosen to reduce our exposure to global leveraged finance to finance an increased weighting to emerging market (EM) debt, notably EM local currency debt.
Fig 1: Falling default rates
Source: Moody’s, December 2017
Investment grade credit spreads have tightened on the back of inflows and tax reform in the US and ECB bond buying in Europe. Breakeven spreads – the cushion to absorb higher spreads without posting negative excess returns over core rates - are low underscoring the importance of active management of market and liquidity risks. More positively, the opportunities to supplement modest beta returns from active credit selection are rising with greater dispersion and the possibility of more M&A.
The combination of low default risk, rising rates and volatility and yield convergence with high yield bonds means that leveraged loans are increasingly attractive to us, especially relative to high yield bonds in Europe despite the rise of ‘cov-lite’ issuance. Convertible bonds – another low duration asset – also typically out-perform in an environment of rising equity markets and interest rates.
Rising global growth, higher commodity prices and weak US dollar is a macro backdrop typically associated with emerging market assets out-performing their developed market counterparts. Valuations are more attractive and we expect continued inflows from global investors that remain under-weight emerging market assets relative to historical allocations.
Fig 2: Higher EM local bond yields
Note: Global Treasury yield is Barclays Global Aggregate Treasuries yield to worst EM local yield is JP Morgan GBI-EM yield to maturity
Source: Macrobond, Bloomberg, as at 8 February 2018
EM corporates are in the credit-friendly balance-sheet repair stage of the leverage cycle, with the notable exception of Asian high yield, and we project the default rate to be just 2%. We believe EM credit valuations remain attractive and the differential with DM credit is likely to further compress.
As a longer US duration asset class, returns on EM ‘hard currency ‘ sovereign debt (EMD) are more vulnerable to higher US interest rates than corporate debt. Nonetheless, we expect stronger growth to allow spread tightening to partially offset higher US rates. In recent Fed hiking cycles, only in 1994 did emerging market debt post negative returns and EM economic and credit fundamentals are stronger than prior to the US Treasury market ‘taper tantrum’ of 2013.
Exposure to local currency denominated corporate as well as sovereign debt in our MAC strategies was increased at the start of the year. In our opinion, it is an asset class that offers the greatest potential for high single-digit and even double-digit returns. EM currencies remain ‘cheap’ by historical standards underpinned by high real interest rates and improved external finances. We do expect however significant variation and volatility across currencies driven by country-specific idiosyncratic factors against the backdrop of a busy political calendar, notably general elections in Brazil and Mexico.
The key downside risks are a sharper than anticipated slowing of Chinese growth; a global ‘trade war’ (two risk factors that would hurt global risk assets as well as EM); and a resurgent US dollar. In our view, the risk of a China ‘hard landing’ are small and ad hoc sector-specific protectionist trade measures will not meaningfully hinder global trade. Convergence and global growth will continue to pressure the US dollar despite Fed rate hikes as will the widening US trade deficit on the back of increased capex and fiscal stimulus.
The Fed is leading the global transition to the post-QE monetary policy era that is driving volatility and term and inflation risk premiums higher in core rates markets. The improving economic and inflation outlook for Japan is likely to prompt the BoJ to taper its extraordinary monetary policies. Similarly, in Europe, the stronger than (market) expected economic performance is bringing forward market expectations of the end of ECB QE and subsequent rate hikes. We forecast core government bond indices to post negative returns in 2018 for the first time since 2013. However, greater volatility and uncertainty associated with the transition in the global monetary policy regime offers, in our view, much greater opportunities for discretionary macro and government bond strategies to generate excess returns.
The start of 2018 has been characterised by the market re-pricing for three Fed rate hikes in 2018 and for the 10-year Treasury yield to reach 3% on the back of strong growth, rising inflation expectations and increased government borrowing. For long-end Treasury yields to move meaningfully higher relative to forward rates, inflation must surprise on the upside and/or the Fed signal a higher terminal rate, something we don’t expect over the near-term. Nonetheless, we retain a short-duration basis across our MAC strategies as we believe that the market is still under-pricing the path of Fed rate hikes into 2019.
Fig 3: Implied-market versus FOMC media 'dot'
Source: Federal Reserve, 13 December 2017; Bloomberg, 9 February 2018
The market is currently pricing the ECB to end QE in September 2018 and implying 50bps of rate hikes by the end of next year. Our interactions with ECB officials lead us to believe that current market pricing is too aggressive in light of the ECB’s policy reaction function and concerns over further meaningful euro appreciation. In some strategies, we have tactically added long Euro duration positions as a partial counterweight to our short US duration bias.
The biggest surprise for global bond markets this year may yet prove to be a policy shift by the BoJ. The BoJ is acutely aware of the costs as well as the benefits of negative rates and QE. As economic slack is eroded – unemployment is at a record low – and inflation expectations build, the likelihood of the BoJ beginning to ‘normalise’ policy settings by further reducing its asset purchases and raising its 10-year JGB 0%-0.1% yield curve target followed by a move back to zero for cash rates is under-priced by markets.