Bond returns are not negative so far this year. Yes, that’s right. The bears were too bearish again. Most of the rise in yields came in the month or so after the US election.
Since the turn of the year, bond investors have benefitted from stable to lower core yields, good carry and lower credit spreads. At the same time, equities are roaring. What is going on? It’s a massive sweet spot for financial markets.
Growth is strong and expected to be stronger yet interest rates are still low and there is lots of liquidity. After all, some major central banks are still doing quantitative easing.
Only the Federal Reserve (Fed) is on a different track. That is the biggest challenge to market bulls. A rate hike in March will be absorbed because it is being done for the right reasons. But it won’t be the last and if reflation turns into inflation, rates will go a lot higher.
Bond returns
Again the bond market is confounding the bears. In February, total returns for most bond sectors were very strong. Yields stopped rising and, in many cases, traded lower than their end-2016 levels, while credit benefitted from carry and some additional spread narrowing. With cash levels so high and investors reluctant to chase the equity rally without hearing more details about fiscal plans in the United States, bonds benefitted. Interestingly, both credit and duration rallied with the UK bond markets posting the best returns over the month because of the rally in gilt yields, followed closely by more traditional risk on performance from US high yield and emerging bond markets.
Being in the reflation trade has certainly paid off so far in 2017 even if not a lot has happened on the policy front and the thing that is likely to happen first – another rate hike from the Fed – could, in some circumstances, be taken to be a negative for risk. The fact that it isn’t, tells us how strong the sentiment is.
The next rate hike is being seen in the context of a strong US economy which is good for corporate earnings. Sentiment has driven US stock markets to new record highs and the address by president Trump to Congress kept the good feeling alive in markets.
The starting point for market bulls is that the Trump administration will reform taxes, cutting rates for both the corporate and personal sectors, and that there will be a major ramp-up in infrastructure and defence spending. Coupled with the “buy America and employ America” mantra, this is being seen as extending the US business cycle for a number of years.
To be more sceptical one has to ask questions about the timing of when these policies will become reality or about the extent to which they can be implemented when a Republican Congress might insist on all fiscal plans being fully funded. However, one can’t have much of a view on this because there are no details on timing or scope. So the momentum trade is strong, based on the sensible assumption that something will happen. Trump is not going to renege on the reflation promise.
Fed hiking for good reasons
The shift in market expectations of the chances of a Fed rate hike at next meeting is interesting. The superficial view is that it will happen because the Fed thinks the economy is strong enough and there is enough evidence of inflation meeting the Fed’s target.
Higher growth and inflation is probably good for corporate earnings, supporting the bias to upwardly revise earnings estimates and providing support for higher equity ratings. The move is also seen in the context of an expectation of 2-3 rate hikes this year. It will certainly not be the last but I don’t get the sense that there is a super strong consensus on just how high the Fed is likely to take rates in the end. I guess markets don’t need to worry just yet, as the Fed Funds rate is only going to be 1 per cent, the economy is growing at 2 per cent in real terms and inflation is running at 2 per cent or more.
So rates are still very low and will not be doing much damage to borrowers at these levels. I suspect then, as long as the data keeps on running fairly hot, equities can keep rising. The conversations about whether too much is priced in and that the Trump administration has yet to deliver will keep on being had for some time to come. As they say, it’s the travelling not the arriving.
Does reflation become inflation?
There may be more to worry about if the reflation trade does eventually morph into an inflation trade.
What do I mean by that? Well, current sentiment is based on the expectation that the main stimulus to economic activity is shifting from a monetary regime that has fought against deflation for the last several years to a fiscal regime that is likely to have more powerful multiplier effects, at least in the short-term.
Given the cyclical backdrop this could mean actual inflation moves higher and the monetary policy makers have to engineer quite a profound shift from anti-deflation to controlling inflation. That means much higher interest rates and many economies are not ready for that – especially in Europe.
At the moment, inflation is running at 2 per cent or less for most of the developed world and the increase that we have seen in headline rates over the last six months is merely a mirror image of the collapse in inflation that was experienced in 2015 as oil and other commodity prices fell. Remember the chain of events? China devalued in August 2015 setting off a wave of concerns about a hard-landing and resulting in a major pull-back in manufacturing activity globally. Energy and basic material industries were hammered and bond yields fell to record lows.
A year on from the low in the cycle, China appears to have got back to a stable growth path and appears less willing to accelerate market reforms than it did a while ago. Commodity prices are up as a result of some re-balancing in supply and demand and now we have a new policy setting. For the next couple of years a lot will depend on whether this has just been a bounce in headline inflation and that core inflation is still anchored around 2 per cent, or whether we are going to experience a prolonged rise in inflation coming from a mixture of pro-cyclical policies and some structural factors that could impact on relative prices such that longer-term inflationary expectations are increased.
In that regard I am thinking of what controls on immigration might do to the marginal supply of labour and consequently, to wage rates in some industries. Or what about border taxes or more explicit protectionist policies, raising imported goods and services prices? To be sure there are lots of reasons why long-term inflationary trends may stay very low – demographics, automation, a level of globalisation that can’t be rolled back – but can we guarantee that these are enough to offset other, newer structural factors?
Precious income
Investing in bonds is largely driven by the demand for income. For long-term investors there needs to be a sufficient level of yield to ensure that expected income flows more than compensate for inflation. This is why inflation-linked bonds are so popular amongst pension fund investors as the bonds’ value is indexed to an inflation index over its life. Yes, real yields are low so the income compensation over the inflation rate is not that exciting in most markets, but that is better than having both the income and the capital value eroded by inflation turning out to be higher than expected at the time of making an investment. With inflation risks more evenly balanced than they have been for some time, the rationale for holding inflation-linked bonds relative to conventional nominal bonds is strong – especially for buy-and-hold investors.
Even more active investors in bond portfolios should look to be exposed to the inflation break-even – the difference between the nominal yield and the real yield on bonds – or to shorter dated inflation-linked bonds where the mark-to-market risk of rising nominal and real yields is limited, but the strategy still benefits from the actual inflation accrual as published inflation data rises, and to any increase in inflationary expectations represented by the break-even spread. Equities and commodities can also be used to hedge inflation risk, but bonds do it more precisely because of the indexation and in a multi-asset fixed income portfolio, having that hedge when nominal yields are so low, is very important.
Reflation remains good for risky assets
Because of where we are in the cycle – growth picking up, inflation still moderately low – the rational for holding high yield bonds is also strong. High yield markets have less interest rate sensitivity than investment grade or government bond sectors and pay elevated coupons that provide a good income stream when the economy is in good shape.
At the moment it is not a question of either/or, the reasons for holding high yield and inflation-linked are both reasonably strong. If the cycle evolves in the way I broadly expect it, there will be an incentive to reduce high yield exposure first. This might be prompted by investor sentiment turning against the risk relative to the (lower) yield or by signs of increased leverage or a slowing economy and rising default risk. Or it may be that higher interest rates just make it more difficult for high yield to compete at current spreads. But for the moment there is still a decent spread over government bonds and investment grade and the interest rate risk is low in most high yield markets.
The technicals are strong and we are seeing some recovery stories making a significant contribution to overall total returns. However, I have said it several times recently, we need to watch valuations. Credit spreads continue to narrow and are closing in on the lows reached in mid-2014. In terms of what that means for overall yields, it is lower in Europe but slightly higher in the US given the rise in Treasury yields.
One issue that is attracting a lot of speculation in the analyst community in the US is the impact of potential tax reforms and interest deductibility on cash-flows in the corporate sector. Under most scenarios, investment grade companies benefit the most with, generically, higher yield companies losing out if they cannot offset interest expenses against tax liabilities.
Depending on how this plays out it could be a driver of some re-pricing in the US high yield market, but the devil will be in the details of Trump’s overall budgetary proposals.
Chris Iggo is chief investment officer, fixed income at AXA Investment Managers. The views expressed above are his own and should not be taken as investment advice.