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In Focus: Fixed Income
Fixed Income
Outlook Summary
This Outlook provides a forward-looking summary of the medium-term
views from the Fidelity Fixed Income team.
Macro Outlook: Government bonds & rates
We expect government bonds to generate flat returns over the coming twelve
months. While government bond yields are slightly below our estimates of fair
value, we believe the debt overhang and accommodative monetary policy
should keep a lid on yields. On a longer horizon (beyond 12 months), we expect
the leverage build-up and ageing demographics should act to keep yields
contained compared to previous cycles.
We expect only a modest rise in US Treasury yields over the coming year,
targeting fair value on 10 year US Treasuries at 3.0-3.25% by June 2015. The
FOMC hinted at a first rate hike as early as mid-2015 conditional to seeing not
just growth improvements but more specifically wage inflation as a precondition
towards policy normalisation. The Fed continues to express caution about
the improvement seen in the labour market with unemployment rate masking
weakness in other areas. On the technical side, the improvement in the budget
deficit is reducing the net supply of Treasuries, providing an important offset for
weakening demand from US retail investors.
We expect flat returns from German Bunds over the coming 12 months, with
German government bond yields being broadly range-bound. In contrast, the
relentless rally in peripheral government debt begs the question whether bond
holders are still compensated for the embedded risk. While trade deficits have
rebalanced, the developing deflation story and still elevated debt levels in
Mediterranean economies lead us to expect monetary policy to remain. The
June policy measures taken by the ECB are likely to remain unchanged for the
rest of 2014, which should anchor core and periphery bond yields for longer.
We expect 10 year UK Gilt yields to stay range-bound between 2.5-3.0% over the
coming twelve months, with flat expectations for Gilt returns. UK economic data
continues to surprise to the upside, but the recent fall in inflation suggests spare
capacity still exists. While expectations for the first rise in official interest rates
have crept forward, a relatively aggressive tightening cycle is already factored
into UK bond markets. This should support Gilt valuations in the near term.
Investment Grade Credit
Investment Grade delivered strong positive returns year-to-date and we expect
flat to positive returns from investment grade corporate bonds over the coming
twelve months.
The fundamental picture for credit is modestly supportive although the credit
cycle is clearly maturing. This phenomenon is led by the US, but even there,
event risk seems contained, with leverage down from its x1.8 peak in 4Q13 and
M&A and LBO activity has not yet surpassed growth in market capitalisation.
Overall, we believe the deterioration of fundamentals will play out over a long
period of time and is of idiosyncratic nature, i.e. affecting individual issuers,
rather than a threat to total returns of the asset class.
Investment Grade credit spreads are still above historic tights and around
historic averages. Therefore against the current backdrop of low yields,
valuations remain attractive. While spreads have tightened further across the
asset class, credit is not yet overvalued and we may even see the rally go
further for as long as QE is on. Indeed, credit spreads continue to be a direct
function of liquidity and to a large extent, the deterioration of Investment Grade
fundamentals – still modest in Europe - is seen as less of a concern relative to
that of higher beta credit. We do however see a risk that if leverage is taken on
the presumption that growth will come through, volatility could pick up from its
current cyclically depressed levels.
The Asset Quality Review of the banking sector due in October 2014 represents
a supportive technical factor for financials as politicians and regulators
encourage issuers to remain bondholder-friendly. Most banks are well prepared
leaving us less cautious on the sector. As recovering financials display
accelerating earnings growth and continuing deleveraging, they offset the
slowdown in performance out of non-financial credit and provide support for the
wider Investment Grade bond category. Ultimately, net negative supply should
stay broadly supportive for credit in a low rate environment as investors continue
to reach for yield.
Emerging Debt
EM hard currency debt staged a strong comeback in the second quarter,
outperforming its developed market counterparts. Soft EM growth momentum,
US tapering, growth concerns in China and geopolitical tensions in Russia/
Ukraine has not deter investors loading up on yield and carry. As global rates
stay depressed income will remain a key focus for investors. After such a strong
rally, still mired within a weak growth environment, we expect modest single
digit positive returns for EMD.
Fundamental growth remains sluggish. EM election risk has diminished as many
high profile elections are now over (e.g. South Africa and India). Central banks
are lowering their hawkish guard (examples: surprise rate cuts in Mexico and
Turkey) which puts much needed economic rebalancing and policy credibility at
Technicals are positive. Steady inflows on the back of improving sentiment and
further easing by ECB as see year to date EM fixed income fund flows at +$4.2
Valuations are highly differentiated between asset and individual security
types. When viewed on its own, excluding Asian High Yield, dedicated EM
credit continues to look like fair value to modestly rich. When compared to DM
(Developed Market) high income counterparts (EHY and US HY) EMD yields
continue to remain compelling. The FIL-EMD team prefers idiosyncratic risks
(relative value security selection strategies) over deploying broad based market
beta strategies.
Flows have been concentrated EM hard currency $ sovereigns (high duration
sensitivity ~7.1yrs ). Forward looking, investors should look to substitute EM
sovereign credit spread with EM corporate spread risk. EM corporates have
a better risk / reward profile due to its lower duration sensitivity (~5.2yrs) and
more diversified regional allocation. In a depressed growth environment we
recommend EM local government rate exposure, however EM FX continues to
remain dependant on a pending revaluation of EM Growth fundamentals.
Inflation Linked Bonds
Inflation remains contained across most continents. There are signs of
fundamental inflation pressures in the US via a positive trend in wage growth.
We anticipate that this will filter into consumer prices. Meanwhile, the Fed
remains accommodative and the base rate will likely not increase until mid
to late 2015. In Europe, the threat of deflation has bottomed out. We forecast
inflation to remain positive in the next 12 months and forecast the year on year
European harmonised core inflation measure to be approximately 0.7% to 0.8%
in December 2014.
We have recently increased our US CPI forecast to 2.6% year on year in
December 2014. Recent strong CPI releases have supported breakevens.
Although some of the increases are temporary (air fares, hotels), some
other core components such as housing and rental cost,are unquestionably
accelerating. The trend in PCE, the inflation measure the US Fed focuses on,
should mirror the trend in core CPI, maintaining a 40 to 60 bps gap. PCE is
currently at 1.5% while core CPI is at 2% year on year. We remain bullish on US
inflation funds, especially in the shorter end of the curve.
While current valuations are compelling, markets remain too preoccupied with
current low inflation levels. From here on, however, we expect inflation-linked
bonds to outperform their nominal equivalents. We expect US breakevens
to perform in the coming 12 months on better US economic data. In Europe,
pessimistic sentiment keeps breakevens low. The mispricing between inflation
and breakevens in Europe presents selected opportunities for long positions.
Inflation in EM included in Barclays World Government Inflation-Linked 1-to-10
Year Index is running at or close to the upper end of central bank targets. The
passthrough of a weak currency into inflation is much higher in EM than in DM,
hence any weakness in currencies can manifest itself in a higher CPI measure
with little delay. This has been beneficial to carry in an environment of weakness
in EM. Mexico is attractive from a fundamental growth perspective. The Mexican
economy is showing signs of recovery after a weak Q1 and an unexpected cut
in the base interest rate. Core inflation should start reflecting the economic
recovery going forward.
High Yield
High Yield credit has delivered an impressive return year-to-date. If we annualise
current returns across all the main high yield markets, we would easily print
another double-digit year of performance. Mathematically this is not impossible,
but with a large amount of corporate bonds reaching the call price ceiling, price
upside is limited. Carry is the main focus for the second half of the year.
Broadly, corporate fundamentals are robust but there is a growing divergence
among regions. In the US there is more tolerance for aggressive deals including
a raft of payment-in-kind notes, dividend deals and CCC issues. Weaker
covenants and more aggressive financial policies are not surprising at this
stage in the credit cycle. This trend is more acute in the US, Europe is probably
around 12-18 months behind. Here corporates remain in defensive mode with
the majority of new issuance still for refinancing. Globally, high yield defaults are
low and expected to stay this way over the medium term. Financial repression
has enabled companies to refinance and push out the maturity wall, suppressing
the default cycle.
Technicals have been one of the main drivers of the asset class. Flows favour
Europe where the ECB’s promise of lower for longer has seen investors reach for
high income solutions and Asia which offers a healthy premium. The US has also
seen decent flows with the much debated pronounced great rotation away from
bonds not materialising. However, any technical weakness could exacerbate
downside price movements, especially due to the often illiquid nature of the high
yield market. Supply had a weak start to the year but has picked up over the
past couple of months; both Europe and Asia are on track for another recordbreaking year of issuance.
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