We expect 2018 to mark the beginning of a new era in bond investing as central banks start to withdraw their quantitative easing, with some also set to hike interest rates. Bond investors will need to cast a wider net, with an emphasis on detailed research, active security selection and sector rotation.
By Mark Vaselkiv
Fixed income markets in 2017 were driven by US politics, specifically the waxing and waning of expectations concerning Trump administration policies. The key driver in 2018 will be the extent and speed of central bank tightening, although is not yet clear how quickly individual central banks will seek to do this, nor how it will affect markets. In addition to the withdrawal of quantitative easing (QE), we expect that some central banks will also hike interest rates in 2018 – possibly more aggressively than currently priced in by the markets. If a number of central banks tighten at the same time, it could very well pose a risk, given that yields are still close to record lows, and that government and corporate bond valuations are high.
However, banks are likely to adopt a cautious approach, so liquidity will very probably remain ample for an extended period. The key question, therefore, is: which factor is more important – the change in QE levels (which will be negative) or the fact that QE levels are still substantial? We believe that how the market answers this question will play a major part in determining whether 2018 sees a return to volatility or a continuation of stability.
Uncertainties over trading relationships and Chinese growth pose further challenges. If the negotiations between the UK and EU over Brexit collapse, or if US President Donald Trump delivers on his threat to scrap the North American Free Trade Agreement, the restrictions on trade that would likely ensue could negatively impact global growth. Following the 19th National People’s Congress in October, the Chinese authorities are expected to ramp up their efforts to reform China’s state-owned enterprises and reduce corporate debt, which could slow the Chinese economy in 2018. China’s growth is still expected to come in above 6%, but a downside surprise could cause significant disruption given China’s importance as the world’s second-biggest economy.
Tensions between the US and North Korea show no sign of abating. While full-scale war seems unlikely, the potential impact of any escalation of the crisis on US China relations is a concern. Elsewhere, the threat to European unity has receded following the failure of populist, anti-immigration parties to make major inroads in the Dutch, French, and German elections. However, the Catalan independence movement and ongoing negotiations over Brexit have the potential to unleash further volatility, as does the forthcoming Italian general election.
After several years of slumber, inflation may awaken in 2018. The broader economic environment continues to show improvement, and there is a possibility that central banks may misinterpret underlying inflation signals and stresses.
The past year was notable for its tranquility - bad news came and went without causing much alarm in markets. In 2018, however, a risk event, or a combination of events, could potentially unleash considerable volatility.
Prudence suggests that investors manage risk exposure by adopting underweight positions or adding risk-free assets like US Treasuries to their portfolios.
While government bond yields in the developed markets are low, a number of emerging markets are at different stages in their interest rate cycles and offer higher government bond yields. High yield bonds and bank loans appear to offer better return potential and lower duration than developed government bonds. However, they do not appear cheap in the current environment, and could be vulnerable to any equity market disruption. We believe a ‘barbell strategy’ that pairs corporate fixed income instruments on one side with asset-backed securities or government bonds on the other may offer advantages in 2018.
Another potentially promising approach could be to invest in countries undergoing positive change. We believe Argentina, India, and Indonesia fall into this category, while prospects for Turkey and South Africa are less favourable, in our view.
More generally, given the potentially volatile nature of markets, a willingness to adopt an active approach to security selection and moving between sectors where necessary could be advantageous for bond investors in 2018.
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