The Goldilocks environment that markets saw in 2017 may still have some gas left in the tank, according to Aberdeen Standard Investments investment director of total return credit Mark Munro. .png)
FE Alpha Manager Munro, who runs several fixed income funds for Aberdeen Standard, explained that the global macroeconomic backdrop is still positive at the moment and there is value yet to be found in fixed income markets despite market consensus to the contrary.
The term ‘Goldilocks’ is derived from the fairy tale and refers to an economic environment that is neither too hot to cause inflation nor too cold to cause a recession and in 2017 global markets went into this heathy environment.
He said: “Our gut feel is still that it’s going to be a long goodbye to Goldilocks. This part of the cycle could go on for a while yet.”
Since 2008 the global economy has been in what is referred to in the economic cycle as the expansionary phase.
But certain characteristics such as rising interest rates, high valuations and low unemployment, which are currently in place, are often seen at the end of the expansionary phase.
This could suggest therefore that the cycle is moving on to its next stage, the peak.
While Munro noted that it may not be for some time and said that investors should not say goodbye to Goldilocks too quickly, he agreed that the peak must eventually come and that certain factors are signalling the beginning of the end.
“One of the facets of goldilocks is being removed, and that’s quantitative easing (QE),” he said.
Indeed, the Federal Reserve began its process of unwinding QE towards the end of last year for the first time since the financial crisis, having embarked on an interest rate hiking cycle in 2015 and continuing it this year with expectations of further rises throughout 2018.
Meanwhile the European Central Bank (ECB) has said it will run its current asset purchasing program until September this year, although interest rate rises are not expected in 2018.
But Munro said that the bond market hasn’t reacted to this tightening of monetary policy as violently as some may have expected as the Fed has been careful to signpost its movements.
“There was much chat, there was much concern, there was much conversation, but the market just continued on its merry way,” he said.
“And actually, if you speak to our European corporate and bond investors in general, they’re actually pretty sanguine about this.”
In theory, the removal of QE, which has seen central banks buy back an unprecedented number of bonds, should force yields higher as demand is removed from the market.
However, he added that global growth is very fragile at the moment and that central banks have to continue to walk a narrow tightrope in terms of both withdrawing their QE programs as well as raising interest rates due to the large amounts of debt in global markets, which at $237trn is the highest level ever seen.
“If you go back to 2008, you’d almost think the credit crunch didn’t happen because the amount of debt outstanding in the world has continued to rise on its merry way, almost unbroken bar a tiny blip,” he said.
Munro said the UK is a perfect example of central banks walking this narrow tightrope.
Earlier this year, the Bank of England’s Monetary Policy Committee hinted at an interest rate rise, but after some weak economic data they decided not to in their May meeting.
Nevertheless, the global economy is moving towards a rate hiking cycle, and the bond manager said a gradual rate increase could have a positive effect on credit spreads, whereas a shock rise would be negative.
One thing that doesn’t worry the bond manager is inflation despite increasing oil prices and very high wage-bargaining in Germany.
He said: “It gets a lot of press and a lot of headlines, but you can see last year global inflation continued to soften.”
Nevertheless, Munro did say there were two things to watch out for.
Firstly, he pointed out that there is “an unprecedented amount of fiscal stimulus in the US,” which is something that has not been seen before at this part of the cycle and should be kept an eye on.
Governments typically implement a fiscal stimulus package during an economic downturn to reinvigorate it, so we could yet see more of the current expansionary phase.
Secondly, he said to keep an eye on the US yield curve because the flattening of this curve is “the best predictor of a US recession.”
The below chart shows that when the US 1-year Treasury yield is higher than the US 10-year Treasury yield there is on average a 6-month lag before a recession occurs, which can be seen by the grey bars in the chart.
Difference between 1yr and 10yr US Treasury yields
Source: Federal Reserve Bank of San Francisco
Munro admitted that we are nearing that, but also that the backdrop for risk assets still looks positive.
“We still have time, we still have a cushion where growth is still reasonable, and you can still invest in risk assets.”
He added: “We’ve got fairly robust growth. Emerging markets are a strong contributor to that but developed markets are also doing relatively well, the UK being one of the laggards I’d say.”
Despite this, Munro sees investment grade fixed income in the UK as not being “overly expensive” compared to other high yield markets.
Elsewhere, he sees emerging markets as a region that has positive valuations.
He said: “One of the areas where I think there still is some value is in emerging markets, and that has definitely been the case over the last few weeks as the market has sold off.”
The Aberdeen Standard manager added that high yield leverage in emerging markets is lower than in the US.
Pairing this with deleveraging in Europe, Munro said the fundamentals for corporate bonds are good.
However, he cautioned that the fundamental backdrop will only remain positive for credit markets if there is no central bank policy error and if the US 10-year Treasury yield stabilises.
The US 10-year Treasury has fluctuated recently, moving above and below the 3 per cent mark several times.
“I think we’re getting to a point in markets now where we really could do with what happened in the previous cycle and that is US 10-year Treasuries stabilising in that 3 to 3.2 per cent range,” he said.
Year-to-date yield of US 10-year Treasury
Source: Bloomberg
Finally, Munro advised to keep an eye on the increasing correlation between risk assets and rates.
“The correlation between government bond yields in a world of QE and also risk credit assets has actually increased over the last few years,” he said.