Bond markets are shifting fast from deflation to reflation mode causing greater volatility, but investors should continue to look at credit markets and particularly emerging market debt, according to Société Générale Private Banking (SGPB).
Government bonds have had a tremendous run in 2016 with yields suffering as a result, reaching record lows in the wake of the Brexit vote in June.
But this has been more than just a 2016 phenomenon with government bond yields declining steadily since the financial crisis in 2008 thanks to a global environment of slow but steady growth.
Performance of index over 10yrs
Source: FE Analytics
Since 2006 bond yields in the UK have fallen by 66.79 per cent, reaching a new low in June this year before rebounding slightly, according to the private bank.
In the UK, SGPB Banking says a steeper yield curve remains the most likely outcome as inflationary pressure should drive long-term yields further up.
Analysts at the investment bank said: “The Bank of England (BoE) stands between a rock and a hard place. On one side, sterling’s sharp depreciation boosts imported inflation.”
“On the other, the economic outlook is turning grim with faltering business confidence and expectations of lower foreign direct investment ahead of Brexit negotiations. BoE forecasts signal a high probability of inflation overshooting in the coming two years.”
Given these factors the investment bank suggests the BoE will wait until late 2017 before making any further policy decisions, giving economic conditions time to stabilise.
Elsewhere, the US presidential election was “more of a magnifier than a true game-changer” it notes.
“Fixed income markets starting shifting their focus from deflation to reflation several months ago, as reflected in the modest but steady rise in US long-term yields.”
With inflation rising thanks to a slack labour market and rebound in commodity prices, the private bank expects the Federal Reserve to raise interest rates in December, with a further two hikes next year.
Meanwhile, in Europe and Japan, it says the central banks are running out of firepower, with the extension of current policies likely to remain for some time.
“Against this background long-term yields should continue to rise and with policy rates stuck at low levels, yield curves may steepen further,” the private bank said.
“Bond market volatility has returned, leaving investors concerned. Short maturities should be favoured in the United States and United Kingdom though we maintain a preference for corporate bonds.”
Looking towards the credit side, SGPB likes emerging market debt despite the short-term headwinds still in place.
“After an impressive rally which began in early 2016, the US presidential elections sent emerging market hard-currency debt tumbling again.”
“However this correction was mainly driven by an upward shift in the US yield curve, as markets anticipate a shift in economic policies after Donald Trump’s surprise victory.”
Performance of emerging market debt benchmark over 10yrs
Source: FE Analytics
Over the past five years, emerging market debt has been volatile, with the taper tantrum in 2013 followed by a strong year in 2016.
However, the bank says headwinds for the asset class including higher US interest rates, wide spreads which are more stretched currently (400 basis points) than their five-year average (360 basis points) and a slowdown in investor flows, should all be short-term.
Analysts at the private bank say they are not expecting a sell-off as in 2013, as the Federal Reserve will likely resume a more normal monetary policy approach taking some of the pressure off emerging market debt denominated in US dollars.
“All in all, we think there is still value in emerging market hard-currency debt in portfolios in this environment of supressed yield,” the bank noted. 
It suggests euro-denominated emerging debt as its preferred investment, with the European Central Bank’s dovish stance likely to boost demand for higher-yielding debt in euros.
In Europe, SGPB expects 2016 trends to continue into the New Year, adding: “On the supply side, strong demand and low yields have triggered higher issuance, however the strong supply has not derailed markets.”
“We expect more of the same in 2017: the corporate sector purchase programme and low rates will support demand while supply will remain robust as the growing USD-EUR differential will continue to encourage overseas companies to issue in euros, especially those doing in business in Europe with little need to hedge against currency risk.”
While political risk will remain high over the next year in Europe, this should be offset by an improving eurozone benefiting from the US economic stimulus plan.
“This, together with positive economic growth and ultra-accommodative monetary policies will support euro credit markets,” the bank noted.
“However, spreads are unlikely to tighten much, especially in the investment grade segment, where yields remain near all-time lows despite a recent bounce.
“Given low or negative government bond yields credit markets continue to provide an interesting alternative but mainly on a carry basis.”
In the US, the private bank believes although much is uncertain, Trump’s economic proposals should boost US growth initially.
This would be good news for credit spreads, given they would be supported by higher revenues and a lengthened credit cycle, according to SGPB.
It adds that fundamentals have been improving for some time, with default rates decreasing thanks to a stabilisation in commodity prices boosting miners and oil producers.
However, on a total return basis, “the environment is rather unexciting” with spreads unlikely to tighten much.
“On average, US credit is in late-cycle territory and highly leveraged – this he be a challenge especially if at some point higher rates start to bite and weigh on the sector,” it noted.
The private bank expects high yield bonds to be cushioned by wider spreads, with both investment grade and high yield debt predicted to outperform treasury bonds next year.